Don’t Fall Into the Netflix Trap

by Lawrence Meyers | January 30, 2013 11:25 am

Investors went crazy for Netflix (NASDAQ:NFLX[1]) last week when the company reported better-than-expected earnings … but one always has to look beyond the headline numbers in a quarterly report.

And when it comes to Netflix, I think looking deeper than the earnings beat reveals an ugly truth: The business model simply is not sustainable.

As I’ve said before, Netflix has some $5.6 billion in content obligation[2] payments due in the next five years, while over $2 billion of that is due before September. Oh, and the company only has around $750 million in cash and short-term investments. It’s about to issue $400 million in bonds, of which $225 million might be available for those obligations. In the last quarter, free cash flow was -$51 million.

Add it up.

The company is nowhere near the amount it needs this year, much less the sum it needs down the road. That means the content will get released to other services, the most likely of which will be Coinstar (NASDAQ:CSTR[3]) and Verizon’s (NYSE:VZ[4]) joint Redbox Instant venture. Or maybe Amazon (NASDAQ:AMZN[5]) or Apple (NASDAQ:AAPL[6]) will pick it up, as each has tens of billions of dollars on their balance sheets.

Netflix tries to obfuscate the facts regarding content by insisting that other services[7] don’t have much that overlaps, so they couldn’t serve as a substitute. That argument cuts both ways, though. If Netflix loses premium content because it can’t pay for it, subscribers could bolt.

Furthermore, the comparison to other services are only based on Netflix’s “top 200” titles, itself a dubious metric for comparison. An enormous amount of niche content is viewed by consumers, and it translates to more than just a tiny overall percentage of content streamed.

Meanwhile, the company’s most profitable division — DVDs — will be gone soon. DVD subscriptions dropped from 11.2 million to 8.2 million year-over-year, while revenue fell from $370 million to $254 million, a drop of over 30%.

Streaming subscriptions grew from 21.7 million to 27.1 million, but unlimited streaming at $8 per month will not support the company. And while revenue increased by $113 million, costs increased $75 million and the company backed off on marketing by $30 million. International streaming revenue increased $73 million, but expenses increased by $100 million. The international segment is operating at a loss.

Sure, Netflix is inching into the original programming arena, but don’t count on that to be the savior of the company’s future. Netflix paid over $100 million on its original show House of Cards, a political thriller with Kevin Spacey and Robin Wright, produced by David Fincher. I have no doubt this will be a terrific show (I’ll be watching), but it won’t make a difference to Netflix financially.

DirecTV (NASDAQ:DTV[8]) learned the same hard truth when it picked up Damages from FX. The company hoped that if even a fraction of the non-subscriber audience ordered the service, it’s return on investment would be impressive. After all, DirecTV was screening the show exclusively.

This plan probably didn’t work out… and even if it did, there was no way to measure how many subscriptions resulted. Thus, Damages was considered “a retention play.”  That’s the same language Netflix is using for House of Cards. There will not be any way to measure its success, allowing the company to proclaim what a success it was!

On top of that, the plan is to make all the episodes available at once. If I never had real interest in Netflix but wanted to watch the show, I’d take advantage of their free one-month trial, watch the show and cancel the service. No revenue for Netflix.

There is a model for original programming for Netflix that can work, but this isn’t it.

Of course, that doesn’t mean the stock won’t rise anyway. The market doesn’t care about substance sometimes and there are enough Netflix bulls out there to push the stock higher, possibly for an extended period.

Regardless, I don’t see how the company survives long-term.

As of this writing, Lawrence Meyers did not own a position in any of the aforementioned securities.

  1. NFLX:
  2. $5.6 billion in content obligation:
  3. CSTR:
  4. VZ:
  5. AMZN:
  6. AAPL:
  7. insisting that other services:
  8. DTV:

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