It's Time to End the Love Affair With Netflix

Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Netflix (NASDAQ: NFLX) is somewhat of a cult stock. Indeed, the company has not made a sizable profit for the last two years, but yet, the stock price keeps rising. However, there could be some gaps starting to show in the company's strategy.

For a start

First off, the company's margins. Netflix's gross margins have risen from 61% in the first quarter of 2011 to a high of 74% during the last quarter of 2012. However, margins have now fallen back to 70% as the company struggles to drive revenue higher. On a net basis, margins have deteriorated even more, falling from 8.4% during the first quarter of 2011 to an average of 0.5% during 2012, but then ticking slightly higher to 1.5% this year.

In comparison, close peers Twenty-First Century Fox (NASDAQ: FOX) and Time Warner (NYSE: TWX) have seen their gross margins stabilize at 35% and 43% (in fact, Time Warner's margin has increased slightly from 43% to 44% from 2011 to 2012) for the past two years, respectively. Additionally, Fox and Time Warner have kept net margins steady at approximately 10% for the same period.

Costs are rising

Secondly, Netflix has seen its cost of sales and interest costs rise significantly faster than revenue, stunting growth.

<table> <thead> <tr><th> </th><th> <p><strong>March </strong><strong><span>2011</span></strong></p> </th><th> <p><strong>June 2011</strong></p> </th><th> <p><strong>September 2011</strong></p> </th><th> <p><strong>December 2011</strong></p> </th><th> <p><strong>March 2012</strong></p> </th><th> <p><strong>June 2012</strong></p> </th><th> <p><strong>September 2012</strong></p> </th><th> <p><strong>December 2012</strong></p> </th><th> <p><strong>March 2012</strong></p> </th><th> <p><strong>June 2012</strong></p> </th></tr> </thead> <tbody> <tr> <td> <p>Revenue</p> </td> <td> <p>$718,553</p> </td> <td> <p>$788,610</p> </td> <td> <p>$ 821,839</p> </td> <td> <p>$ 875,575</p> </td> <td> <p>$869,791</p> </td> <td> <p>$889,163</p> </td> <td> <p>$ 905,089</p> </td> <td> <p>$ 945,239</p> </td> <td> <p>$1,023,961</p> </td> <td> <p>$1,069,372</p> </td> </tr> <tr> <td> <p>Revenue Indexed</p> </td> <td> <p>100</p> </td> <td> <p>110</p> </td> <td> <p>114</p> </td> <td> <p>122</p> </td> <td> <p>121</p> </td> <td> <p>124</p> </td> <td> <p>126</p> </td> <td> <p>132</p> </td> <td> <p>143</p> </td> <td> <p>149</p> </td> </tr> <tr> <td> <p>Cost of Sales</p> </td> <td> <p>$438,151</p> </td> <td> <p>$489,978</p> </td> <td> <p>$536,617</p> </td> <td> <p>$575,155</p> </td> <td> <p>$623,933</p> </td> <td> <p>$643,428</p> </td> <td> <p>$662,638</p> </td> <td> <p>$695,867</p> </td> <td> <p>$726,863</p> </td> <td> <p>$753,525</p> </td> </tr> <tr> <td> <p>COS Indexed</p> </td> <td> <p>100</p> </td> <td> <p>112</p> </td> <td> <p>122</p> </td> <td> <p>131</p> </td> <td> <p>142</p> </td> <td> <p>147</p> </td> <td> <p>151</p> </td> <td> <p>159</p> </td> <td> <p>166</p> </td> <td> <p>172</p> </td> </tr> <tr> <td> <p>Interest Cost</p> </td> <td> <p>($4,865)</p> </td> <td> <p>($5,303)</p> </td> <td> <p>($4,915)</p> </td> <td> <p>($4,942)</p> </td> <td> <p>($4,974)</p> </td> <td> <p>($5,006)</p> </td> <td> <p>($4,990)</p> </td> <td> <p>($5,016)</p> </td> <td> <p>($6,740)</p> </td> <td> <p>($7,528)</p> </td> </tr> <tr> <td> <p>Interest Indexed</p> </td> <td> <p>100</p> </td> <td> <p>109</p> </td> <td> <p>101</p> </td> <td> <p>102</p> </td> <td> <p>102</p> </td> <td> <p>103</p> </td> <td> <p>103</p> </td> <td> <p>103</p> </td> <td> <p>139</p> </td> <td> <p>155</p> </td> </tr> </tbody> </table>

Figures in $U.S. millions except for indexation

On an indexed basis, revenue has grown 21% over the last five quarters, while cost of sales has grown 42% and interest costs have only expanded 2%. Still, the rapidly rising costs are a cause for concern, especially when it comes to profitability.


Thirdly, and more importantly, it is the amount of off-balance sheet liabilities that Netflix has stacked up. In particular, the $3.3 billion in off-balance sheet content liabilities that the company has, in addition to its on-balance sheet liabilities which total $2.4 billion (both long and short-term). These off-balance sheet content liabilities total 76% of the company's total assets, and due to their off balance sheet nature, are not subjected to auditor scrutiny.

Moreover, both the on and off-balance sheet liabilities total a whopping $5.7 billion, up 19% YTD, and account for 127% of all Netflix's assets. Lastly, Netflix is hemorrhaging cash, spending $200 million a month, excluding debt issuance, just to fund the business.

Look somewhere else

On the other hand, well established peers Fox and Time Warner stand in much better positions. Fox has a solid balance sheet with assets covering liabilities twice and Time Warner is in the same position.

One thing is for certain, neither company has the same dire fiscal position as Netflix. In addition, both companies have strong free cash flows and they are returning large amounts of cash to investors:

<table> <thead> <tr><th> <p>Company</p> </th><th> <p>Time Warner</p> </th><th> <p>Fox</p> </th><th> <p>Netflix</p> </th></tr> </thead> <tbody> <tr> <td> <p>Stock Buyback</p> </td> <td> <p>$1,958</p> </td> <td> <p>$2,885</p> </td> <td> <p>-$69 (Issuance)</p> </td> </tr> <tr> <td> <p>Dividends</p> </td> <td> <p>$1,027</p> </td> <td> <p>$654</p> </td> <td> <p>0</p> </td> </tr> <tr> <td> <p>Debt Issuance</p> </td> <td> <p>-$80 (reduction)</p> </td> <td> <p>+$288</p> </td> <td> <p>+$270</p> </td> </tr> <tr> <td> <p>Free Cash Flow</p> </td> <td> <p>$2,198</p> </td> <td> <p>$2,265</p> </td> <td> <p>-$27</p> </td> </tr> </tbody> </table>

Figures over the last four quarters $U.S. Millions

Time Warner and Fox are both returning large amounts of cash to investors while maintaining a strong free cash flow and minimal debt issuance.

Numbers aren't everything

Numbers are not always the best way of analyzing a business, so how does Netflix look from a different view? Well, the company is facing increasing competition from both Apple's iTunes, Google's YouTube, and Amazon's streaming service -- oh! And Hulu. So, there is plenty of competition in the sector, but Netflix has retaliated with original programming. So far, this has failed to turn things around and the company is spending more for less as revenue growth is still lagging spending on content. It remains to be seen if this drive for original content will benefit Netflix, but unless the company comes out with a blockbuster, competition is only increasing in the sector and Netflix is struggling to stay ahead of the game.

Meanwhile, Fox is making blockbusters, the most recent of which is Wolverine. The company is also bringing in cash with well established Fox News, Fox Sports, and other pay-TV channel's. As far as Fox is concerned, the company is well established, has its key audience, and is making money without having to produce its own expensive content -- all reasons to believe that the company's strong cash generation will continue for years to come.

Time Warner has a cult style about it as the company is responsible for producing many 'comic' films that always have a strong fan base and are highly lucrative. That said, its pay-TV division is losing market share to Netflix, but the cash generation from successful films should give Time Warner plenty of room to compete and stay ahead of the game.

Foolish summary

All in all, there appear to be some serious flaws in Netflix's business model. The company is stuck with shrinking margins, huge off-balance sheet liabilities, and rapidly rising costs.  Indeed, with liabilities totaling just under 130% of assets, it would appear that there is a lot of risk in Netflix.

On the other hand, the company has some good points in the form of revenue growth (at the expense of margins) and a revolutionary business model. 

Still, perhaps it would be prudent for the average investor to look at Netflix's more established peers, Time Warner and Fox.

The television landscape is changing quickly, with new entrants like Netflix and disrupting traditional networks. The Motley Fool's new free report "Who Will Own the Future of Television?" details the risks and opportunities in TV. Click here to read the full report!

Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool recommends Netflix. The Motley Fool owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus