This Netflix Backlash Is Ridiculous

Apparently, it's cool to trash Netflix (Nasdaq: NFLX  ) again.

This morning's Wall Street Journal details how studios and premium movie channels are fretting over Netflix's growing power -- and how they aim to disarm it before it dominates digital video the way Apple (Nasdaq: AAPL  ) cornered the market on digital music.

Mill Rock LLC short-seller Manuel Asensio also took his shots on CNBC on Friday. In a segment kicked off with a "Horror Flix" graphic, Asensio argued that the stock won't hit the $600 million in earnings that some of the more aggressive analysts are targeting come 2013. He also voiced his doubts about management's credibility and the integrity of its recommendations engine.

The fine line between struggling and thriving
As a Netflix shareholder since 2002, I'm always receptive to bearish arguments. I'm not entirely comfortable with the stock's lofty valuation, given the industry's volatile future. No one knows how we'll be watching video at home a few years from now, even if I obviously believe that Netflix will play a major role.

However, Asensio's argument didn't really work for me. For starters, he actually called Netflix a company that is "struggling to survive" during his appearance. I'm not sure I would classify a cash-rich company that rang up nearly $110 million in free cash flow over the past year as fodder for the endangered species list. Revenue and earnings grew by 31% and 26% respectively in the company's latest quarter.

It's one thing to knock's Netflix's valuation, but are we really discussing the viability of a company that has profitably grown its subscriber base over the past year by 52%, to 16.9 million subscribers?

Netflix expects to add another 2.1 million to 2.8 million net subscribers this quarter, closing out the year with nearly 20 million subscribers. At some point next year, it will likely pass up the slower-growing Sirius XM Radio (Nasdaq: SIRI  ) and the declining Comcast (Nasdaq: CMCSA  ) to become the country's most popular premium subscription entertainment service.

Asensio mocks Netflix's churn, but it'll always be high. There are no initial equipment investments or long contracts to sign, as you will find with many other subscription offerings. It takes only a few keystrokes to become a Netflix subscriber. It takes even fewer mouse clicks to become a former Netflix subscriber.

At $19.81 in average costs per gross subscriber addition -- a tiny fraction of what cable and satellite television companies are paying -- let it churn. If a subscriber on most of the company's plans sticks around for just two months, Netflix has already made back its money and then some

The reality of $600 million
Most analysts feel that Netflix will be earning a lot less than $600 million in three years. Let's see whether their math holds up.

Netflix doesn't need to grow subscribers fourfold to quadruple this year's projected $150 million in profitability. The company runs a scalable business model, even if it doesn't necessarily feel that way right now.

Revenue isn't expanding as quickly as its subscriber rate, because new members are gravitating toward the entry-level plans that include unlimited streaming. Earnings aren't growing as quickly as revenue, because Netflix is investing in big-ticket licensing deals for streaming content.

This is a tactical maneuver that will likely reverse itself next quarter. After all, Netflix is hiking the prices of its most popular plans with a streaming component by $1 to $3 a month. It'll some resistance from subscribers, and churn will be tested. However, the end result will be huge.

Let's go with 19.4 million subscribers by the end of 2010 -- the midpoint of Netflix's guidance. Suppose that the average member will pay $2 a month more next year. Add it up, and we're talking about just more than $465 million in incremental revenue.

Will it largely trickle its way to the pre-tax earnings line? Not necessarily. Studios will demand more money for their streaming content as their contracts run out. Streaming costs will escalate, as we're seeing during the peering fee battle breaking out between Comcast and primary content delivery partner Level 3 (Nasdaq: LVLT  ) . Churn may get hairy, as some couch potatoes balk over Netflix's first rate hike in six years.

However, the end result is that Netflix is likely to earn far more than the $205 million that analysts see the company earning next year. This company has routinely topped Wall Street's bottom-line estimates, but it may do so by an exaggerated margin in 2011.

Do you really want to miss that? Do you want to be short? Asencio's firm has been short since August, leading one of the CNBC anchors to point out that the stock has soared 66% since he began betting against the company.

Do you want to be on the wrong side of Netflix come 2011?

Netflix in 2013
Netflix will still face near-term challenges. This morning's Wall Street Journal reports that Amazon.com (Nasdaq: AMZN  ) is considering a streaming service that it will bundle with its popular Amazon Prime premium shopping program.

Some studios may sidestep Netflix altogether, though it'll be hard for them to ignore the one growing premium streaming service at a time when pay-television cord-cutters are gaining momentum, and DVD sales continue to fall.

Asencio mocked this summer's costly deal with Epix as non-exclusive, but who will pay studios as much as Netflix can?

See, it's too late to stop Netflix. You can't kill it in the crib. It is the Apple iTunes of digital video. Upset it at your own risk if you want to play hardball with content deals.

Now that Netflix is apparently achieving initial success in Canada, how many more countries will be streaming come 2013? Once the content-building arms race passes and margins begin to widen again -- and this model once again becomes scalable -- how much more will Netflix be making on each subscriber of its larger global base of users?

The shares will be volatile, but at what point will it make sense to short Netflix? In retrospect, it sure didn't make sense this summer.    

Is Netflix heading higher or lower in the near term? Share your thoughts in the comment box below.

Apple, Amazon.com, and Netflix are Motley Fool Stock Advisor selections. The Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Longtime Fool contributor Rick Munarriz has been a Netflix shareholder -- and subscriber -- since 2002. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


Read/Post Comments (25) | Recommend This Article (20)

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 December 06, 2010, at 8:32 PM, EquityBull wrote:

    My concerns with Netflix are competition from apple and if streaming is the future (and it is) then Netflix will have to pay much more for first run content and shows. They would have to up their price model and eventually it may not be any different from your cable bill. Or cable may just come down a bit while netflix comes up and they meet in the middle. Then you ask why is netflix any better if cable has new shows, new movies and on demand?

    Too much room for the disruptor to become the disrupted. My money is on the sideline on this one and I'll just enjoy watching it as the consumer in the end will be the ultimate winner

  • Report this Comment On December 06, 2010, at 8:40 PM, Mstinterestinman wrote:

    Ill keep my money elsewhere bought at 100 and sold at 150 because

  • Report this Comment On December 06, 2010, at 8:42 PM, Mstinterestinman wrote:

    I found better investment opportunities but great company maybe ill miss out on some gains but without a dividend not enough potential reward to mitigate the risk and lofty valuation.

  • Report this Comment On December 06, 2010, at 9:13 PM, colddish wrote:

    Netlix will be acquired by Google or some other monolithic entity and the shares will end up way more than they are now.

  • Report this Comment On December 06, 2010, at 9:14 PM, FoolSolo wrote:

    Are you really expecting NFLX to live up to its current valuations? Let's look at the numbers for a second....

    PE > 73, P/FCF > 105, Debt/Equity > 1.2, and their profit margin is just a bit over 7%.

    Those are some awfully high expectations.

    The Level-3 spat with Comcast (http://news.cnet.com/8301-30686_3-20024571-266.html) is not likely to go in L3's favor. Comcast is the largest provider of consumer broadband, and they also have their own "on demand" cable offering. I don't know if L3 was counting on dodging the fees when they bid and won the Netflix deal, but if they were this could ruin them.

    There is other competition as well, so Netflix's margins are not likely to change much from where they are now. I can't see NFLX maintaining these valuations, but I've been wrong about this for about 6 months, so the trend may likely continue.

  • Report this Comment On December 06, 2010, at 9:34 PM, Tryinman11 wrote:

    What is even more astounding than these willy nilly analysts, are the lemmings that apparently keep buying Netflix believing it will rise like a rocket forever. Unfortunately, I'll have to admit the price will go up in the short term, not because of fundamentals but the short squeeze which has been in play for months, which tends to attracts buyers daily. 2011 may not be as rosy as previous years, as I forsee a slowing of income and subscription growth which will help clear people's minds.

    Streaming is maturing, and others such as Roku.com offer several streaming channels, with Netflix just being one option. Content will play a key part in NFLX's survival, and the studios are working overtime to limit NFLX's growth.

  • Report this Comment On December 06, 2010, at 11:43 PM, cadiehl1 wrote:

    "with Netflix just being one option"... only problem is Netflix IS the reason ROKU exists.... it is their ONLY real sale... Netflix is awesome... look at what Roku is offering and you slip back to Nelflix and just watch a movie instead of all the other fun but silly stuff on there... it is what it is ..... no one can catch them,, they smartly put together something that is going to continue to dominate.... there are many You Tubes out there... but You Tube dominates.... because they are the best.... jump on NFLX.. make some money... watch some flix... I did... more than tripled... and holding.

  • Report this Comment On December 07, 2010, at 1:54 AM, StocksRider wrote:

    I agree with the overall sentiment in this article. Spins are being put by all and sundry on pure facts. Here is another classic example of how ZeroHedge put a spin on what turned out be just a programmed sale by the CFO - http://ibankcoin.com/king_of_the_pg/2010/12/03/nflx-%E2%80%9...

  • Report this Comment On December 07, 2010, at 8:05 AM, modeltim wrote:

    Key take away here - It is the Apple iTunes of digital video". I'm not going to bet against that.

  • Report this Comment On December 07, 2010, at 9:01 AM, brandonmatthews wrote:

    the problem with netflix is they changed the time frame of free trials, which boosted their sub numbers to include non paying subs and erroneously reduced the real churn number.

    they did it to themselves...

    going to take a quarter or two for Wall Street to recalculate

  • Report this Comment On December 07, 2010, at 9:19 AM, joshpritchard wrote:

    Without the questionable stock buybacks the company engaged in this year, EPS growth in Q3 was ~19%, the same growth the company re-iterated for it's Q4 guidance.

    19% EPS growth. Forward P/E > 50.

    The competitive landscape is getting worse, not better.

    Q4 will probably be a big quarter on subscriber growth, but lookout for free users jumping again, then time to account for a whopping 9% of total subscribers (up from 6% in Q3, and 3% in Q2).

  • Report this Comment On December 07, 2010, at 9:28 AM, BioBat wrote:

    The competitive landscape should and could get better but it is not better right now. It is non-existent.

  • Report this Comment On December 07, 2010, at 10:23 AM, Richwhynot wrote:

    One thing left out of various equations seems to be just how much customers LIKE the way Netflix operates. I've been a Netflix customer since it started. I have never gotten better treatment by any company than from Netflix. They have built up tremendous good will with customers. When one thinks about the dissatisfaction that people have with phone companies, cable companies, etc., Netflix is a dream. Should a person move and suspend an account Netflix instantly responds and issues a credit, no problem. Try that with cable, or anything you have with automatic bill payment, it takes sometimes months to stop. Netflix thinks long-term, and it is honest.

  • Report this Comment On December 07, 2010, at 10:38 AM, Richwhynot wrote:

    Please pardon this second comment.

    Who is to say that Netflix will remain a company locked in a single field? Smart companies evolve.

    People are concerned that Amazon and Apple will poach on Netflix's territory, but what if Netflix gets into downloading music, too? Using a subscription-type system? With a base of 19+ million happy movie subscribers, that could really be something.

  • Report this Comment On December 07, 2010, at 11:17 AM, Pandorabelle wrote:

    You can't object to backlash toward a company that has earned it.

    1) NFLX has attempted to mislead by inflating sub numbers with extended and free subs--many of which were giveaway incentives; a healthy company has no need to use smoke and mirrors to generate confidnce

    2) NFLX owns no proprietary business; all they do is lease content for distribution...which can be done easliy by whoever can pay the most

    3) NFLX is one of the biggest BANDWIDTH piggies, using over 20% in prime time and will be hit HARD when forced to pay for usage (which will naturally be passed along to the customer!)

    4) NFLX has NO MONEY-next to no cash on hand and very limited opportunity for growing subs without hefty rate hikes---which will drive people to competitors with deeper pockets who can charge less and give more...better

    All that combined with the outrageously bloated fundamentals leads to only one conclusion; they had a good run, but it's done. Dinosaurs were all cool in their own eras.

  • Report this Comment On December 07, 2010, at 1:42 PM, trish556 wrote:

    Why pay $2/episode via Amazon or Apple, when you can instantly stream unlimited shows for less than $10/month? Amazon's new streaming interface is not as user-friendly as Netflix's.

  • Report this Comment On December 07, 2010, at 2:13 PM, BioBat wrote:

    Sundolly,

    1a) You, me, or just about anyone else could have gotten a free month long subscription from Netfllix long ago (I did in Q1) - all you had to do was search for it. Now it's become more standard, across the board but it was always available.

    1b) Considering the low churn of NFLX subscribers (currently at 3.8%), some free subs should hardly matter as history shows most subs overwhlemingly stick with the program.

    2) Yes they do. The recommendation engine is very much a proprietary feature from their customer relationship management software built in house. They also built their own state of the art supply chain management system. Considering how good, no check that, considering that they're better at both than any company I've even done business with, their technology could be easily licensed (if they so desired although I doubt that's in their business plan). There is also the hardware, software, and security architecture they have in place to deliver all those great movies to us without a glitch. Again, all proprietary and all developed in house.

    3) Comcast just announced they are not about to lower their usage caps (currently at 250 GB).

    4) Netflix has money and they have opportunity to continue increasing subscribers through NA and even moreso through international expansion. English Canada was the first test case, Frech Canada will be next, then Europe, India, Japan, etc.

  • Report this Comment On December 07, 2010, at 5:34 PM, Pandorabelle wrote:

    BioBat,

    The CFO just jumped ship. Cashed in ALL is chips and said buh-bye. Not a month notice for transition in good times... Some dirty laundry will surely be aired. Pull your head out of .....the sand. What else can I say...?

    Insider trading investigation....no cash flow...limited if any-abilty for dilution or to raise cash. Anything getting in there?

  • Report this Comment On December 07, 2010, at 8:17 PM, FoolSolo wrote:

    As I said before, with the debt and valuation numbers NFLX is sporting, you would be crazy to buy into this gig right now. Their profit margin of 7% is not going to produce the revenues and profit projections the street is expecting. There is an overwhelming amount of optimism baked into the price, and when NFLX waivers, even slightly, the reality will bring this baby crashing down.

    If you have their stock, use defensive measures and lock in your profits, it was a great run. But if you are thinking about opening a new position or adding to it, I would highly suggest you do some math on these numbers.

  • Report this Comment On December 10, 2010, at 12:28 PM, Colo14ersguy wrote:

    NFLX has been my nemisis. Owned it years ago about 20 and sold at a loss when competion heated up with Blockbuster. Big Mistake. Now I just bought again at 190. My only real concern is that the fools recommending it don't fall in love with it soo much that they won't be able to make a sell recommendation on the stock. Until then I am in the game again on this one.

  • Report this Comment On December 10, 2010, at 1:24 PM, masterN17 wrote:

    The only people bashing NFLX are the ones who are short.

  • Report this Comment On December 10, 2010, at 1:48 PM, Borbality wrote:

    I'm with FoolSolo on this one. Great company and it's not their fault investors are running wild with it. Much harder to make expectations than to disappoint, I would think. It's been a great run and I wish i was in on it. I wouldn't short it either though! No telling how long the crazy will last. but as a consumer i hope netflix can dominate and keep prices low. All my devices are netflix ready and I don't want to switch.

  • Report this Comment On December 10, 2010, at 10:47 PM, stan8331 wrote:

    I've yet to hear one semi-convincing argument that any of the Netflix competitors actually offer a better deal for a product of equal or better quality. Very few Netflix customers are going to switch from to Apple or Google just because of their impressively massive market caps.

    If Apple, Google or anyone else can offer me the same or greater number of titles, along with an equal or better user experience at a significantly lower price, I'll be willing to consider a switch. Otherwise, it's just a bunch of hot air and wishful thinking by those who own Netflix competitors and/or are selling Netflix short.

    Absent any REAL competition, if the short sellers win out and NFLX suffers a precipitous drop, I'll be very thankful for the opportunity to back up the truck to buy more.

  • Report this Comment On December 11, 2010, at 8:53 AM, Derby1942 wrote:

    Netflix is the Amazon of movies. They are good to customers. That is the mark of a great company .

    There is no real competition ; they have made shopping for movies entertainment. No way to fail!

    Plus as the baby boomers stay home from a youth oriented Hollywood , they will sit on the couch, happily pay the fee and enjoy good film.

  • Report this Comment On December 20, 2010, at 6:05 PM, rovobo wrote:

    NETFLIX has been berry -berry good to me I sold half my holdings, got my investment back and then some. I will let the rest ride it out till the bitter end, I can't keep up with all the technology out there , but

    Net flix is doing a good job it so far

    Thank You , MOTLEY FOOL

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