Netflix Keeps Defying the Naysayers

by Kevin Kelleher | February 17, 2011 5:00 am

This is the thing about culture wars. Both sides make up their minds early on and quickly dig in for the long term. After a while, they stop listening to each other. Then their words inflame each other. Eventually, reality takes a back seat to the shrill debate.

The culture war I’m talking about has nothing to do with the political landscape, but rather the increasingly profitable corner of culture that involves watching movies online — which is to say, the company now making a tidy profit on that corner: Netflix (NASDAQ:NFLX[1]).

A few weeks ago, analysts were expressing concern that Netflix’s ambitious plans to expand its video library would weigh down margins. Many approached[2] its fourth-quarter earnings to yield evidence that licensing fees would expand just as subscription growth would begin to slow.

But like a well-plotted thriller that became a surprise hit, Netflix posted so-so earnings followed with guidance for the current quarter that was so strong it that pushed the stock 32% higher over the last three weeks.

The surprise left analysts and investors — who had been so confident about the challenges facing the company — scratching their heads. Several analysts raised their ratings on the stock and others upped their price targets. And Whitney Tilson, whose arguments for shorting Netflix were so detailed they drew a response [3]from CEO Reed Hastings, threw in the towel and covered his short position.

This was the opposite of a cliffhanger, it was more like a hero rocketing from the bottom of a dark valley to the top of a cliff’s edge. Once again, Netflix had vanquished the naysayers. And the world was once again safe for its growing herd of bulls.

But if analysts are caving in to the Netflix growth story, the hardcore bears are not content to merely stay bearish – they are also growing more vocal. Since the company’s fourth-quarter earnings, the bulk of the analysis[4] on SeekingAlpha — a community of often but not always thoughtful DIY stock analysis — is weighed strongly against Netflix’s bright future.

The bears cite many negative factors, most of them surrounding the twin threats of rising licensing fees and declining subscriptions. But one big thread running through their arguments involves operating cash flows, which fell 8.6% in the most recent quarter to $96.7 million. For all of 2010, operating cash flows fell 15% to $276.4 million.

Cash flows are essential to a company like Netflix, which must rely on cash to transition from a dying revenue stream (DVDs by mail) to a growing one (streaming videos). And of course the biggest drain on cash flows came from the cost of acquisitions for its streaming content library, which ballooned to $406 million in 2010 from $64 million in 2009.

This is indeed enough to set off alarms of prudent value investors. But there are exceptions to the rule, and one is when investments that are draining cash flows show early signs of paying off. For now, Netflix is showing such signs.

Netflix added 7.7 million net subscribers last year, more than double the 3.6 million it had predicted. A year earlier, Netflix added 2.9 million net subscribers, which was an increase of 1 milion over the 2008 figure. Something Netflix is doing is bringing in a lot of new subscribers[5].

Tilson – the value investor who closed out his short – offered a few compelling reasons [6]why. While gross margins declined in the fourth quarter, operating margins grew to 13.1% from 12.6%. Netflix cut its marketing spending, he said, even as it saw a surge in new subscribers.

Strong subscriber growth seems to be trumping a drop in operating cash flow – or rather, it seems to be more than justifying that drop. Tilson’s firm surveyed Netflix users and found that they were on the whole streaming more movies as time passed. Most were satisfied with the service, saying Netflix’s streaming library may be incomplete but it’s a great value. And they loved the easy-to-use interface.

So once again, the bullish view of Netflix is winning out. Yes, at nearly $240 the stock is overvalued – Morgan Stanley cut its rating on the stock on valuation concerns – but for all the red flags Netflix’ risky bet is putting on its balance sheet and cash flow statement, the risks are paying off for now.

But that outlook is only redoubling the Netflix bears conviction. And the culture wars continue.

Endnotes:

  1. NFLX: http://studio-5.financialcontent.com/investplace/quote?Symbol=NFLX
  2. approached: https://investorplace.com/29219/netflixs-nflx-streaming-push-may-pull-down-profit/
  3. drew a response : http://seekingalpha.com/article/242653-netflix-ceo-reed-hastings-responds-to-whitney-tilson-cover-your-short-position-now
  4. analysis: http://seekingalpha.com/symbol/nflx/investment-views?source=qp_more_investment_views
  5. bringing in a lot of new subscribers: http://www.readwriteweb.com/archives/netflix_adds_77_million_subscribers_in_2010_to_pas.php
  6. a few compelling reasons : http://seekingalpha.com/article/252316-whitney-tilson-why-we-covered-our-netflix-short

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