Debunking the Myth of Netflix's "Unsustainable" Business Model

Netflix (NASDAQ: NFLX  ) is really a very simple business in its streaming-focused incarnation. Spend money on content licenses and original shows, pay a minuscule amount of upkeep to keep the digital streams rolling, and cash in large profits as the as-yet-unmatched service attracts millions of new subscribers with very low marginal overhead costs.

The picture grows a tiny bit murkier when you factor in the costs of expanding the service to new international markets, but domestic streaming has become more profitable than the DVD-based cash cow. The long-term margin improvements from this strategy are juicy and undeniable.

But some industry watchers worry that Netflix is spending itself into a corner. The chief proponent of this theory is Wedbush Morgan analyst Michael Pachter, who takes every opportunity to call Netflix's model "unsustainable." The Street writer Rocco Pendola is another heavy critic, and Pendola just launched another attack on Netflix CEO Reed Hastings' "smoke and mirrors, dog and pony show."

In this diatribe, Pendola leans heavily on the assumption that Netflix is spending money faster than making it. Here's the keystone to the entire argument, quoted from an earlier Pendola article:

See if you notice a pattern in this series of numbers: $194,499, $150,419, $175,207, $159,199, $508,053, $395,992, $402,251, $370,298, $290,291. Those numbers represent, in chronological order (and in thousands), Netflix's cash and cash equivalents over the last nine quarters, ranging from the quarter ending Dec. 31, 2010, to the most recent reported quarter ending Dec. 31, 2012. ...

That pop -- from $159,199 to $508,053 -- came when Netflix had to hit the market for extra cash at the end of 2011 as things really began to unravel.

At first glance, it all makes sense. Netflix is borrowing money and not building up cash reserves. A classic scam, right? Pendola compares it to maxing out his credit card to pay utility and grocery bills.

But where did Netflix spend that 2011 cash infusion? That's a question Pendola doesn't seem interested in answering. Here, let me help:

NFLX Cash and ST Investments Chart

NFLX Cash and ST Investments data by YCharts.

The "cash equivalents" that Pendola focused his wrath on don't include Netflix's short-term investments, which are securities not quite liquid enough to count as cash. It's a bundle of low-risk assets, mainly "corporate debt securities, government and agency securities and asset and mortgage-backed securities." Hardly cash burned on an open fire, nor pumped into risky content bets.

Taking all of this into account, that scary sequence of falling cash balances loses its sting. Compare and contrast:

I think it's pretty obvious from the stable net cash line that Netflix is being responsible with its cash reserves. Pendola missed a vital component of this calculation, which led him to believe that Hastings is basically tricking investors. If you make the same mistake, you might confuse a rock-solid and opportunistic business with an unstable mess, thus missing out on a tremendous investment.

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  • Report this Comment On May 31, 2013, at 8:32 PM, adamlevy wrote:

    Nice article Anders.

    It will be interesting to see if the company can maintain that net cash line in the face of rising content costs and expiring contracts. That's what worries me about the company.

    That and increased competition/reluctance to raise rates will likely put pressure on the company's margins. It's biggest competition - Amazon - doesn't care about margins for its video service, but it's all Netflix has.

  • Report this Comment On June 02, 2013, at 7:39 PM, jb757 wrote:

    Excellent article. I wish Pendola would comment on it.

  • Report this Comment On June 04, 2013, at 1:51 AM, The1MAGE wrote:

    Pendola did comment on it. He wrote an article calling it "lazy reporting". (Along with attacking a few other writers.) He only mentioned something about grabbing a couple of numbers, and slapping a couple of charts together. He also referred to the writer of this article as "some dude." But really he didn't defend against this article, just attacked it. (Forgive me for saying he seems to be the lazy reporter.)

    I have a little app on my tablet that I check daily to see how my stocks are doing. It brings up articles that are often related to the stocks I own. (Although when it thinks an article on the Amazon rain forest is related to stock in Amazon, I wonder how they are filtering things.)

    But it keeps bringing up these Rocco Pendola articles that show how much he hates Netflix.

    One of his articles he mentions how Netflix has too much debt coming up, and will go bankrupt as a result. He did throw out a big number of all that was due, then a smaller, but still big number that was due this year. But it wasn't double the profit they made last quarter. I think that means they can afford it.

    He seems to think the previous crash is going to happen again, not realizing it was a PR problem, not a financial one. (Though the PR issue did turn into a financial one.) If he doesn't understand that, then what does he understand?

    He also mentioned loss of content, again while complaining that they are going too far into debt paying for content.

    He also brings up a letter by Hastings around all the PR issues, about how Netflix was going to expand, and had enough cash to cover it. Hastings was wrong, but that was one of the results of their PR problems. They had an expansion plan based on certain numbers, but with their temporary drop in numbers, they had to rework their plan based on the new numbers.

    Sure he was wrong, but he is not psychic.

    I have tried to find something of substance with Pendola's comments on Netflix. But at this point I am ready to avoid anything this guy writes.

    Netflix may end up bombing, or maybe they actually do get pushed out of the market by new companies, or they have another PR issue come out, or maybe the government tries to help them. (The worst thing possible.) But no matter what, if this company fails, it won't have a thing to do with anything Pendola has ever written out the company. But he will be there to take full credit. Then again if the company stays a success, I doubt he will admit being wrong.

  • Report this Comment On June 04, 2013, at 6:11 AM, TMFZahrim wrote:

    Right, Pendola's response can be found here: http://www.thestreet.com/story/11939047/1/calling-out-lazy-f...

    That article doesn't merit another sotry in response, but a comment might be appropriate.

    One of his problems with my story was that I presented some numbers without a deep qualitative dive. Kind of like he does, all the time. I'm no household name superstar or anything, but The Fool does syndicate to every news portal that matters and I've covered this company since 2006. And I cover it often -- 116 stories in the last year, ranging from looks at single data points to deep dives into strategy.

    In doing so, I find it impossible not to have noticed Pendola along the way. Or other frequent analysts/reporters/industry watchers in the Netflix space like Mike Olson, Michael Pachter, or Barton Crockett. I know what these people stand for, even if I don't always agree with their points of view. Shouldn't Rocco keep tabs on the Netflix discussion like I do? Seems like he doesn't, and hasn't for the last 7 years. If I'm the kettle, Rocco Pendola looks like a pot.

    Accordingly, I'll cross-post this comment to Pendola's de-debunking story too. That way, he might actually notice the discussion.

    It's kind of a shame to see Pendola not doing his homework on a stock he writes about so often. I do appreciate his views on Pandora; We both enjoy hockey and a certain New Jersey rocker. Seems like a cool dude to hang out with over a few beers. But he's dead wrong about Netflix, because he's not paying attention to details like complete cash reserves or the first-mover advantage Netflix developed.

    Anders

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