Could Netflix Bounce in 2013?
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Few, if any, long-term Netflix (NASDAQ: NFLX) shareholders would express satisfaction with the company’s share price performance over the past 12 months. Shares of NFLX touched a new 52-week low of $60.70 on June 1, capping an ignominious 80% slide from just over $300 in July 2011. Yet shareholders and prospective investors may have reason to be optimistic about the company’s prospects in 2013 and beyond.
Netflix reported fairly poor results for the first quarter of 2012. EPS fell from $0.64 in the final quarter of 2011 to -$0.08. Revenues, however, grew on the previous quarter and on the same quarter of 2011, led by the domestic segment in terms of dollar amounts.
Nevertheless, gross, operating, and net income margins have been sliding steadily and substantially for several years. Moreover, Netflix continues to rely on subscriptions to its DVDs-by-mail service to prop up net income. Although management officially altered corporate strategy to place emphasis on streaming services rather than DVDs and there are more than twice as many streaming subscriptions as by-mail subscriptions, the latter makes
outsized contributions to both revenue and net income. NFLX is adding new domestic and international streaming subscribers rapidly but streaming accounts are significantly less profitable than DVD-by-mail subscriptions on average. And since the company separated the two account types and raised prices on the latter, Netflix has been hemorrhaging by-mail subscribers.
The squeeze in profitability related to international expansion and the shift in focus to streaming content subscription is negatively impacting operating cash flows at a time when the company is investing in content library expansion and launching its own content delivery network (or CDN). The company’s interest coverage ratio has increased substantially and its obligations related to content licensing are also growing. In its most recent 10-Q, the company recognized that the added costs related to licensing content and international expansion may cause negative cash flows for 2012.
Thus, Netflix is investing in greater content variety and its own CDN while accepting higher marketing costs from international expansion and shifting corporate focus to less profitable streaming services. On the face of it, the coalescence of these factors seems to pose a great threat to the long-term profitability of the company.
Nevertheless, several factors may contribute to surprisingly strong performance in 2013 despite poor projections for the remainder of 2012. First, NFLX has ceased hemorrhaging customers at the rate that it saw following the mail-in and streaming services divorce. And although mail-in subscriptions continue to fall, streaming subscriptions – though less profitable – are growing rapidly. Revenues are also growing quickly – though at a slower rate than the cost of revenues. If the company can increase margins on streaming services and reduce mail-in subscription losses, or even reverse such losses, its financial position would be vastly improved.
Second, Netflix’s expansion required a dramatic increase in marketing expenditures, rapid subscriber growth in international markets should soon pay dividends and initially high marketing costs abroad will begin to fall. If the initiative is successful, international markets could soon provide a significant boost to revenues and profitability.
Third, NFLX’s launching of its own content delivery network will reduce the company’s dependence on third-party CDNs and will ultimately pad profitability since the company will no longer be subject to price fluctuations for content delivery services.
Regardless, Netflix confronts a treacherous path back to the stellar growth and market confidence that propelled share prices above $300 in July 2011 for many reasons. First, in recent quarters, cost increases far outpaced revenue growth while margins and indicators of management efficiency slid substantially. Reversing these trends will be difficult since many of the factors driving them are entirely or partially external. Second, the company’s aggressive expansion into international markets carries substantial risks including macroeconomic risk in European markets, currency risk, and the possibility of insufficient infrastructure in some locales. Third, competition is fierce. Direct competitors include: (1) the ‘Prime’ service of Amazon.com (NASDAQ: AMZN), which offers lower annual rates than Netflix, and (2) the Apple TV of Apple (NASDAQ: AAPL), which costs $100, and allows customers to rent or purchase titles for an additional cost of $1 to $3. Indirectly, Netflix faces the obvious competition from cable providers, though it may be the Redbox kiosks of Coinstar (NASDAQ: CSTR) that have the most potential to pull customers away. To learn more about the monster potential of Coinstar and its army of automated kiosks, continue reading here.
Additionally, content licensing costs are rising and the cost has thus far been only partially offset by economies of scale. Netflix simply is not large enough to fully take advantage of such economies at present but this circumstance will improve over time if the company can continue to add subscribers – the more additions, the better. Finally, NFLX is subject to considerable risk that it will not be able to continue to develop its technology at the rate needed to retain a competitive advantage. Competitors such as Amazon and big cable companies have the benefit of vast resources available for developing technology. In contrast, Netflix is already accepting lower profitability in order to follow through with current content licensing obligations and international expansion while keeping the lid on increases in technology spending.
Overall, Netflix’s profitability is being squeezed but continued subscriber growth is a significant bright spot for the company. As the market for video content trends toward streaming as a primary means of content delivery, Netflix’s shift away from mail-in-services will prove to be a wise move. Netflix was the first mover in streaming content and is the largest provider of such services in the U.S. but its future success is uncertain. Second quarter results may give an indication of how fast the company can recover from (or possibly defy) poor projections for 2012.
The stock is a risky investment. Hold it or avoid it for now. But look for improving fundamentals in 2013 – especially subscriber growth – and a possible share price bounce. WealthLift’s Sentiment Index rates Netflix as a hold/moderate sell, with 53.85 percent of users placing an underperform rating on the stock.
This article is written by Denis Hurley and edited by Jake Mann. They don't own shares in any of the companies mentioned above.. The Motley Fool owns shares of Apple, Amazon.com, and Netflix. Motley Fool newsletter services recommend Amazon.com, Apple, and 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. If you have questions about this post or the Fool’s blog network, click here for information.