Should I Sell Netflix Today?

I'm a longtime customer and shareholder of Netflix (Nasdaq: NFLX  ) . My faith in both the service and the company was shaken to the core this summer, as CEO Reed Hastings made one "this changes everything" move after another, culminating in the horrible Qwikster idea.

Now that Qwikster has been dumped in a shallow grave, I'm ready to take a long, hard look at all the things I assume to be true about Netflix. As we dive into this exercise, I'm coming from a place where Netflix looks reasonably cheap but doesn't scream "Buy me!" Let's see if I feel different at the end of it all.

Without further ado, here are the three most important things I think I know about Netflix.

1. Netflix has a real lead in digital movie services
The premise: Netflix was the first to sell streaming video on a subscription basis, not even charging extra for that service for the first few years. Try as it might, Amazon.com (Nasdaq: AMZN  ) never presented a real challenge with the anemic content library attached to the Prime free-shipping plan; Apple and others didn't even try, focusing on pay-per-view or pay-to-own options instead. This left Netflix standing alone to dominate a profitable niche market.

What's new: Hulu is looking for a well-heeled buyer with serious digital-media ambitions, and it looks more like a real rival now that Netflix admits that TV episodes make up more than half of all streaming views. Also, DISH Network is trying to get some value for its Blockbuster purchase by slapping the name on an online streaming service. Even Wal-Mart is stepping back into the ring with its Vudu service. Competition appears to have built up a head of steam.

So what: Like ships crossing in through thick fogs, most of the new competitors still don't really compete in the same market as Netflix. And why would they? Netflix willingly cedes the lucrative new releases and direct sales to focus on a low-cost service that doesn't make economic sense to newcomers. Management walked away from its Liberty Starz (Nasdaq: LSTZA  ) deal because Starz wanted to treat Netflix like another cable company. That attitude doesn't fly in Los Gatos. So the laser-like focus on an ignored yet large market is still intact. So is the moat.

Verdict: Nothing has changed.

2. Earnings don't matter yet; subscriber counts do
The premise: Netflix is too busy shoveling cash and GAAP profits into marketing campaigns and content licenses to worry about massive profits yet. Forget P/E ratios, profit margins, and EPS until the market is saturated and the content library as full as can be -- just keep an eye on rising subscriber numbers for now.

What's new: You may have heard that the pricing changes did some damage to Netflix's customer growth over the summer. The second-quarter report in July closed out with 25.6 million subscribers, including 24.6 million in the United States. After taking a look at how people voted with their feet when the new, higher prices took effect, management told us to expect about 24 million domestic subscribers in the third quarter. That's not growth, it's shrinkage. Furthermore, the guidance came before Netflix introduced our stillborn friend Qwikster, which caused at least one Fool to cancel her subscription immediately. We don't know how deep that additional damage goes.

So what: If operating margins ever go below 10% or above 15%, management misjudged something. These are numbers totally under control, and you still shouldn't expect drastic increases here. The operating leverage play is many years down the road. But the customer-count worry is for real. The third-quarter earnings report in two weeks will tell us exactly how deep the Qwikster cut goes, and it could be bad. That being said, 24 millions unique domestic subscribers would still represent 43% year-over-year growth at the new, more profitable subscription rates, which is pretty high by Netflix's historical standards.

Verdict: I'm on needles and pins to learn more about the Qwikster fallout.

3. The company's finances are in order
The premise: Critics often point to low cash balances plus a staggering amount of off-balance sheet liabilities and then scream bloody murder. Do these people ever notice that Netflix has kept cash balances low and steady for years without going out of business?

What's new: Those off-sheet balances keep moving through the income and cash-flow statements before landing on the balance sheet as library assets and accounts payable or "other liabilities." For example, Netflix moved content from several large deals with Viacom, Comcast's (Nasdaq: CMCSA  ) NBC Universal, and News Corp.'s Fox onto the balance sheet in the second quarter, increasing the relevant balances by $420 million. Yet earnings stayed within the 10%-15% margin range alongside $86 million in positive operating cash flows.

So what: The off-sheet balance keeps ballooning, as do the content licenses they represent. And that much-touted billion-dollar balance is a gross figure (as in "raw," not necessarily "disgusting"): Take out the pieces that already moved through the income statement, and you have only $425 million of costs unaccounted for.

Verdict: This is much ado about nothing.

Final verdict
All told, there is nothing obviously wrong with my old assumptions about Netflix, save for the as-yet unknown quantity of subscribers cancelling over the Qwikster debacle. I'd expect maybe 100,000 to 200,000 people following in our disgruntled Fool's footsteps. Anything more would be very bad news.

So that's what my eyes will be glued on when the earnings report comes down the wire, and I suggest you watch the subscriber counts closely as well.

To pass the time until then, you could check out this free video report on why your credit card will be obsolete very soon.

Fool contributor Anders Bylund owns shares of Netflix but holds no other position in any of the companies discussed here. The Motley Fool owns shares of Wal-Mart Stores and Apple. Motley Fool newsletter services have recommended buying shares of Wal-Mart Stores, Apple, Netflix, and Amazon.com, creating a bull call spread position in Apple, creating a bear put spread position in Netflix, and creating a diagonal call position in Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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, follow him on Twitter or Google+, or peruse our Foolish disclosure policy.


Read/Post Comments (3) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 13, 2011, at 4:49 AM, walt373 wrote:

    I'm afraid you missed the core of the short thesis, content costs. It is a question of what kind of content $8/month/user can buy. Netflix has been getting content at a massively undervalued cost for years. Content providers are now repricing content to a fair value. Netflix needs to readjust costs or revenues to stay profitable - either raise subscription rates or cut content. They've already started doing both.

    Meanwhile, as these adjustments take place, Netflix's brand will deteriorate. For years, users have been spoiled by getting far more than $8 worth of content and that created a lot of goodwill for Netflix. Their expectations have been set at a level that Netflix can no longer fulfill. Now they are forced to disappoint users.

    You mention operating leverage - I would argue that they had it for a few years, but it was temporary because content providers will no longer allow it.

    Regarding the off-balance sheet liabilities, they are large but in and of themselves not an imminent threat - assuming growth continues. They were very aggressive in acquiring content and did not leave much room for mistakes. Then Qwikster happened.

    Please see my blog post here and feel free to comment: http://caps.fool.com/Blogs/why-netflix-is-still-a-sell/64972...

  • Report this Comment On October 13, 2011, at 10:05 AM, dwot wrote:

    walt373's comment is excellent and I tend to think it will affect the bottom line far more then increase subscriptions. We already saw that the market is saturated at the current price and services, otherwise you would not lose so many subscriptions.

  • Report this Comment On October 13, 2011, at 12:12 PM, caltex1nomad wrote:

    Netflix is here to stay. With streaming becoming available to Latin America and a possible move into Europe, Netflix will have a huge subscriber growth spurt. With the current content deals and the ones they are making this is going to mean big $$$$.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1568832, ~/Articles/ArticleHandler.aspx, 10/23/2014 2:06:56 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated 4 hours ago Sponsored by:
DOW 16,461.32 -153.49 -0.92%
S&P 500 1,927.11 -14.17 -0.73%
NASD 4,382.85 -36.63 -0.83%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

10/22/2014 3:59 PM
AMZN $312.97 Down -2.36 -0.75%
Amazon.com CAPS Rating: ***
CMCSA $51.49 Down -0.70 -1.34%
Comcast Corp CAPS Rating: ***
LSTZA.DL $0.00 Down +0.00 +0.00%
Liberty Media Corp… CAPS Rating: ****
NFLX $374.65 Up +8.66 +2.37%
Netflix CAPS Rating: **

Advertisement