Netflix Eats Your Shorts

A month ago, Netflix (Nasdaq: NFLX  ) CEO Reed Hastings sparred with all-star investor Whitney Tilson over the wisdom of selling Netflix short. Hastings rounded off the exchange by saying: "Shorting a market leading firm as it is driving a huge new market is a very gutsy call. On balance, I would rather have my co-philanthropists on the long side of this particular bet."

The proof is always in the custard, and last night's fourth-quarter report was rich and creamy. Netflix delivered earnings of $0.87 per share on $596 million in revenue, while 3.1 million net new subscribers pushed the customer list above the 20 million waterline.

The stock is up 14% on the news, breaking all-time highs in intraday trading and rewarding investors with a spiffy-pop if they invested as recently as December 2008. Naturally, the short-sellers are hurting. In this light, it's hard to call Hastings "defensive" for engaging in the Tilson tussle.

This simple chart clearly reveals the core of the report:

Here, millions of new Netflix subscribers are doing a respectable impersonation of a blue hockey stick. Behold the fruits of an increasing reliance on digital video streams and fewer red DVD mailers. Hastings predicts an S-curve shape to his company's growth, in which case we just hit the rapid-growth part of that trend.

The 28-day delay that damaged Coinstar's (Nasdaq: CSTR  ) Redbox results so badly clearly didn't slow down Netflix at all. Rising content costs are also a reality, but not enough to hobble profits in any meaningful way. Likewise, potential competitors like the Hulu Plus service and the Apple (Nasdaq: AAPL  ) TV box couldn't hamstring Netflix this time. In fact, the Apple TV probably helped more than it hurt, because Netflix streaming is featured front-and-center on that device.

Finally, Hastings notes that Netflix video may indeed be a major consumer of Internet bandwidth to our homes, but that it doesn't create much of a load on the backbone infrastructure. Since the video streams are handled by the distributed networks of content delivery servers managed by Akamai Systems (Nasdaq: AKAM  ) , Level 3 Networks (Nasdaq: LVLT  ) , and Limelight Networks (Nasdaq: LLNW  ) , very little traffic passes beyond their regional traffic centers. Netflix characterized any attempts by service providers to wring extra fees out of consumers for this traffic as bald-faced profit grabs.

I'm not surprised by any of this, except perhaps the vigor of the market reaction. Netflix is proving its business model to plenty of doubters, one quarterly report at a time.

I wonder if Whitney Tilson got any of his shorted shares out of harm's way. He did have fair warning, after all.

Add Netflix to your watchlist to help you stay on top of its opportunities and threats. The Fool will cover them all in high resolution.

Akamai Technologies is a Motley Fool Rule Breakers selection. Apple and Netflix are Motley Fool Stock Advisor recommendations. The Fool has written puts on Apple. The Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days

Fool contributor Anders Bylund owns shares of Netflix but holds no other position in any of the companies discussed here. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. You can check out Anders' holdings and a concise bio if you like, and The Motley Fool is investors writing for investors.


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  • Report this Comment On January 27, 2011, at 8:52 PM, MKArch wrote:

    Did ever look at the income statement? Gross profit was *DOWN* sequentially. They beat estimates entirely due to slashing marketing expenses and their tax rate going from 42% to 37% sequentially. If they didn't slash marketing and the tax rate stayed the same they would have come in at $0.66, missed estimates by a nickel and earnings would have dropped sequentially for the second straight quarter. It's unbelievable that no one is calling them on this.

  • Report this Comment On January 28, 2011, at 12:00 AM, verylargelarry wrote:

    MKArch....

    Gross profit payeth no debts, but free cash flow does nicely. Take a look. Helps acquire more content, too.

    What seems unbelievable to me is that you analyze this amazing growth engine and fail to see what is sending this stock to the heights.

    The market may be calling you on this.

  • Report this Comment On January 28, 2011, at 5:29 AM, uupdnn wrote:

    when netflix recently increased its subscription rates, and many subscribers had to readjust their type of subscription,,,,are these considered"new subscribers" and the one time increase in income, from the increased rates, was that figured in the latest earnings report. Netflix is a terrific company and really broke through and offered a product that was,is,greatly appreciated by consumers, for many reasons, but the stock price could go either way as it is factored for perfection, at present. Tulips were the most valuable commodity in the world once,,,the visual can often be confused with something else.

  • Report this Comment On January 28, 2011, at 5:30 AM, TMFZahrim wrote:

    Thanks for the assist, Larry. Also, "slashing marketing" would lead to stunted growth for many a fine firm. Netflix got the opposite outcome. It's easy to lower marketing spend when your service is getting more sticky and SAC is going down. Personally, I would have preferred an earnings miss along with another million subscribers, but Hastings chose to take his foot off the accelerator just a smidge. Oh well. Maybe he's earned the right to run the business his own way.

    Anders

  • Report this Comment On January 28, 2011, at 8:08 AM, MKArch wrote:

    You can't grow into a 60X multiple by slashing marketing costs and a mysterious plunge in tax rates. If gross profit doesn't go up NFLX will run out of operating expenses to cut and growth will come to a grinding halt.

    Not only *DID* the content costs hurt them (they were masked by slashing marketing and a lower tax rate) but Anders forgot about Tilson's point that content costs on their income statement are lagging cash costs and will have to catch up. He also forgot that they signed and expensive deal with Disney at the end of Q4 that has yet to show up on their income statement as well as the eventual Starz renewal.

    I'm a long time TMF sub and know TMF prides themselves on digging into the numbers. I'm surprised that of the two TMF articles I've seen so far both have drunk the Kool Aid and given them a complete pass.

    I don't remember the exact numbers but there was a post on NFLX m.b. last night pointing out that when you divide the q/q increase in revenue by the average revenue per sub the number of subs doesn't come close to the increase they reported. He did a similar calc with paying subs that didn't compute. Did you enjoy the prescreened questions asked by the moderator on the cc? No more information on subscriber metrics after 2011? Maybe there is more to the CFO cashing out and leaving the company than claimed.

  • Report this Comment On January 28, 2011, at 8:14 AM, MKArch wrote:

    BTW Larry what happens to fcf as they start shelling out cash for the new content deals?

  • Report this Comment On January 28, 2011, at 8:31 AM, MKArch wrote:

    Scratch the comment about increase in revenue not matching subscriber growth. It was late when I read it and a couple others claimed the math worked so I just took their word for it. I just checked and unless I'm missing something he's wrong. I stand by the rest of the points though.

  • Report this Comment On January 28, 2011, at 11:00 AM, SigmaSwan wrote:

    Anders, agreed on all points. One nugget from the release that I haven't seen much mention of, the Starz deal doesn't expire until 2012! Remeber all that fussing about content costs and how Netflix is getting an amazing deal with Starz that cant last forever. Well, it's gonna last at least another year.

  • Report this Comment On January 28, 2011, at 11:11 AM, verylargelarry wrote:

    MKArch...

    To answer your question, we'd be wise to look at the past because Netflix has already "started shelling out cash" for content deals. Starz, Epix, WB off the top of my head.

    Each time, I hear it overpaid, or its customers will not wait 30 days, or its content providers will raise the prices (to the rapidly growing, largest customer already?) or that Redbox will destroy them.

    I also note some votes of confidence in the company.

    But, to answer your question, it seems that after Netflix shells out money for content, it, well, it GROWS. The facts are that it has grown EXPONENTIALLY from time to time, as now, but at worst, its growing steadily, while cutting acquisition costs and experiencing bulging revenues, for years now.

    You might try the service; one can get a clear picture almost anywhere.

  • Report this Comment On January 28, 2011, at 11:51 AM, MKArch wrote:

    Larry,

    Exponential growth doesn't last forever eventually it runs up against the law of big numbers. In NFLX case it's already happened. Net income was *DOWN* from Q2-Q3 and would have been *DOWN* again from Q3-Q4 if they didn't slash marketing expenses and their tax rate didn't mysteriously drop from ~42% to ~37%. You can't grow your way into a 70X multiple by cutting operating expenses and lowering your tax rate.

  • Report this Comment On January 28, 2011, at 12:37 PM, BioBat wrote:

    MKArch,

    Eventually it's going to catch up but I don't think it's there yet.

    The slash in marketing spending is very significant yet you discount it as cost reduction (which it is). Netflix did this and grew customers another 10-20% in the quarter. You'd be hard pressed to find another company that could do the same.

    Also, Netflix rates are going up this month so the margins are likely to increase again - some will trade down but most of the new subscribers, by that I mean anyone jumping on in the past couple of years, have stuck with the 1 DVD or streaming only plan and their rates will increase $1 a month.

    Lastly, Netflix has taken a hit moving into Canada - another reason for not hitting one out as far as you would've liked - but look like they're going to be profitable there within a year. It's not a big market but first mover advantage and a million or so subscribers will help add to the bottom line. Expect similar things to happen when they go international.

  • Report this Comment On January 28, 2011, at 1:21 PM, MKArch wrote:

    Biobat,

    NFLX is trading at 70X earnings. They have to grow earnings at something like 50% a year for the next five years just to be worth what they are trading for right now. Sure saving money by cutting marketing is a good thing particularly when it didn't seem to hurt subscriber growth this quarter but it's not repeatable over any significant period of time and it was the *ONLY* reason other than their tax rate plunging earnings were up sequentially instead of *DOWN* for the second straight quarter.

    If NFLX was trading at 15X earnings I wouldn't be posting here but they're not, they're trading at 70X with huge content cost increases still to come and no reason why competition can't repeat what they do and undercut them to gain share. I didn't see anything in the unaudited numbers that gave me faith they would live up to their current share price and Tilson was wrong. In fact the announcement that they won't provide standard subscriber metrics after 2011 tells me they don't see high sub growth lasting much longer/ churn will be a problem soon. Not good for a stock priced for more than perfection.

  • Report this Comment On January 28, 2011, at 3:26 PM, verylargelarry wrote:

    Arch,

    First, simple observations -

    "NFLX is trading at 70X earnings. They have to grow earnings at something like 50% a year for the next five years just to be worth what they are trading for right now."

    I feel they are worth exactly what the market says they are worth. I feel people recognize where this company is going and, obviously, are paying more than average prices for its value. If Netflix is able to grow earnings at a 50% annual rate (as it has), I would expect an even higher multiple after 5 years!

    "Sure saving money by cutting marketing is a good thing particularly when it didn't seem to hurt subscriber growth this quarter but it's not repeatable over any significant period of time and it was the *ONLY* reason other than their tax rate plunging earnings were up sequentially instead of *DOWN* for the second straight quarter."

    Here, you are just wrong. Listen to the call. Perhaps you would agree that other factors affected earnings. Like the extra customers sending in a check every month. The evolving high profit steaming only option.

    "huge content cost increases" -- who says?

    Hastings simply admits that no content is absolutely necessary and that if the content cannot be acquired sensibly, they'll pass. He's more concerned with subscriber adds and keeping those 17 million happy. Er, 20 million. Also don't forget that when he sits in on those negotiations, he's the one that brings money to the table. Do you think some feel Netflix may someday be viewed as the proxy for the paying public the content providers are trying to reach? 20 million love 'em!

    "no reason why competition can't repeat what they do and undercut them to gain share." -- Seriously, here's 9 billion dollars. Er, 11 billion. Think you can build the equal of Netflix??? The market does not believe you can. And the competition (whoever they could be) agrees.

    " In fact the announcement that they won't provide standard subscriber metrics after 2011 tells me they don't see high sub growth lasting much longer/ churn will be a problem soon."

    Again, listen to the call. They will discontinue subscriber projection, not reporting subscriber metrics. Hastings says they've demonstrated no particular expertise in doing so, so he feels it yields no particular value, so they won't continue it. Many companies do not issue projections of any kind, yet you've misinterpreted this to an astounding degree, which leads me to:

    Last, the Complex Observation...

    I think you are trying too hard to be the boy who noticed the King has no clothes.

    Me, I'm ridin' with the (well dressed) King.

  • Report this Comment On January 28, 2011, at 4:06 PM, MKArch wrote:

    Nobody cared about things like realistic P/E multiples and what was coming down the road in 1999 Larry and riding the King seemed to work real well in 1999. Not so much in 2000. Riding the King worked for stocks like TAZR, CROX and KKD until it didn't work.

    BTW do you think the deal they did for Disney re-runs at the end of the Q was free? Do you really think STARZ is going to re-up for $30M a year again? Gross profit was already down sequentially not even including these upcoming additions to content costs but who cares about stupid stuff like that. Nobodies ever lost money betting on King momentum.

  • Report this Comment On January 28, 2011, at 4:11 PM, MKArch wrote:

    BTW Larry I got to the top 1% of CAPS largely by betting against King momentum.

  • Report this Comment On January 28, 2011, at 5:32 PM, verylargelarry wrote:

    Arch..

    Top 1% is an achievement to be commended. Nice.

    With your sharp perspective, you may agree that some differences apply between 1999 and now. High multiple company actually booking profits is a stark difference, for one.

    Also, you'll see the futility of comparing NFLX to TAZR, CROX and KKD. Respectively, accounting matters, the passage of the fad, and the poor expansion mgmt sunk those stocks and NFLX shares none of those risks, to my opinion.

    "BTW do you think the deal they did for Disney re-runs at the end of the Q was free?" Of course not. (Why do you go to hyperbole?) But you seem to feel Disney is so anxious to raise prices that they will do so to the detriment of one of its best sources of income. I think not. Disney will treat NFLX with a lot more respect than you. And then both companies will release statements highlighting how happy they are with the deal, just as always over the last 5 years. And Disney will go about making more movies to sell to NFLX and NFLX will go about gathering more subs to deliver to. Past is prologue.

    "Nobodies ever lost money betting on King momentum." Sarcasm and hyperbole don't present the best picture of your thinking. But, yes, eventually every King ages, but he certainly doesn't always crash. I would not feel too bad being long Microsoft for the past 10 years, as long as I bought 20 years ago, ya know?

    NFLX is a position that I will maintain until shortly after readers like you stop building that wall of worry that I've climbed for over 5 years now. I've heard every fear floated by the shorts and, well, you know what's happened.

    Thank You!

  • Report this Comment On January 28, 2011, at 5:48 PM, verylargelarry wrote:

    Arch,

    I lost my all-star ranking. Topped out at 93 or 94%, then lost it, then decided a better game is to actually record your trading within Scorecard. That is my current habit.

    After entering every trade I've ever made, I've scored an internal rate of return (annualized) of 17.8%. This figure neglects yearly cash withdrawals, sometimes 5-6% of my principal. I left my mutual fund positions and began investing for myself in late 1993.

    I am pleased with this performance. I hope you have exceeded it!

  • Report this Comment On January 28, 2011, at 6:33 PM, MKArch wrote:

    You don't think companies like CSCO and MSFT were making money in 1999? You might want to check their charts since then. NFLX is exactly TAZR, CROX, KKD a story stock that momentum players have driven up way beyond what they could ever justify with their future earnings potential.

    BTW NFLX isn't Disney's best customer the MSO's are and NFLX just inked a *NEW* deal with them that has not yet hit cost of content on their income statement but will be adding substantially to it in the coming quarters as will the STARZ deal when they sign it and even the Epix deal they signed over the summer may not be fully accounted for in their earnings. There are boat loads of new content costs coming down the pike and based on management stating they will cease providing standard metrics of subscriber growth in 2012 it's a safe bet they see an end to high sub growth and they see churn as an issue they would rather not discuss.

  • Report this Comment On January 28, 2011, at 6:36 PM, MKArch wrote:

    BTW when you check out the charts on CSCO and MSFT you should also note that both have had substantial revenue and earnings growth since 1999.

  • Report this Comment On January 28, 2011, at 7:01 PM, verylargelarry wrote:

    Arch,

    I get it. You don't like NFLX here.

    I urge you to short the stock!!!

    Do you have real skin in the game or do you just pontificate and play make believe on CAPS?

    BTW, NFLX rose another 3.3% today on a day when the S&P fell 1.5%. Another all time high two days after the release of quarterly stats that you find so troubling.

    I think there's something going on here and you don't know what it is, do you, Mr Arch?

    Good night sir, last word is yours.

  • Report this Comment On January 28, 2011, at 8:18 PM, BioBat wrote:

    Arch,

    Netflix is trading at 70x trailing PE. Considering they've grown by 60% over the past year, using trailing earnings to project valuation is underestimating things just a little. Their forward PE based on earnings estimates is 36 - that's still high and should rightfully give some people pause but it's not that outrageous for a tech stock.

    And NFLX still hasn't hit a PE anything like the 200 that CSCO, the 390 Yahoo, or the 750 Ebay reached at the height of the market ridiculousness in the early 00s. The point - none other than the market can remain irrational longer than anyone can time.

    As long as Netflix remains on the upward slope of growth, nothing is going to cause the stock to come in line with a PE at or near 15. It's just not going to happen. When growth stops, the stock will either go flat for a while (years) or drop. That much is pretty certain. Timing that is about as much a guess now as anything. It's clearly not at a good point to start a position and shame on the major investment houses for calling it a buy, buy, buy yesterday after calling it a sell, sell, sell for many (if not most) of the past quarters. These guys are so late the the party it's not funny. But it's a fine stock to hold if you've gotten in anywhere below 50% of where it's at now or take some profits on.

  • Report this Comment On January 28, 2011, at 9:29 PM, MKArch wrote:

    Biobat how do you know what the forward P/E is when managment can't even give guidance for 2011? I can say for sure they won't come anywhere near a P/E of 36 with gross profit going backwards q/q. How is this a high growth story when EPS was *DOWN* from Q2 to Q3 and would have been *DOWN* again Q3 to Q4 if they hadn't slashed marketing expenses and their tax rate didn't plummet from ~42% to ~37%?

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