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.