Call me a glutton for punishment.
Granted, I got off light last week, escaping defeat by the skin of my teeth after presenting the bearish case on Internet overlord Google (NASDAQ:GOOG). Today, though, I've been tapped to critique Netflix (NASDAQ:NFLX).
After it's knocked off dirt-cheap DVD-renter Wal-Mart (NYSE:WMT).
After it's driven bricks-and-clicks rental rival Blockbuster (NYSE:BBI) to the brink of bankruptcy.
You wait until now to ask me to make the case that Netflix is doomed?
Sure, man. Sign me up. Netflix is doomed.
What? You want more?
Fine. How about this -- in a world of 500-channel cable television, a world populated by TiVo (NASDAQ:TIVO)-brand DVRs to record that programming, and Scientific-Atlanta (NYSE:SFA)-brand clones that record the programming just as well, a rent-by-mail entertainer like Netflix is irrelevant.
At The Motley Fool, we take to heart the investment wisdom of former Magellan Fund captain Peter Lynch, to "buy what you know" -- and conversely, to not buy when you know enough to know better. Well, this Fool knows Netflix. I've rented from it for years, off and on, and as a Netflix customer, I guarantee you -- Netflix has more than one chink in its armor.
Call them "Mr. Burn"
Granted, Netflix has bested all comers in the DVD wars. Wal-Mart's thrown in the towel. Blockbuster's practically belly-up. Amazon.com (NASDAQ:AMZN) is still dithering over whether it wants to get involved in this mess. Netflix stands all but alone, its pricing power reviving, with the promise of cash profits (perish the thought) becoming more real day-by-day.
But although Netflix already looks profitable under generally accepted accounting principles, accounting profits aren't really the ones that count, now are they? No, Fools understand that GAAP profits won't pay the electric bill. For that, you need cash. And cash (or more specifically, the free flow thereof) is what Netflix lacks.
It wasn't always so. Leafing through Netflix's 2004 10-K, you can see that a year ago, Netflix generated $29.6 million in free cash flow. So on a trailing free cash flow basis, Netflix was recently valued at 41 times annual FCF. Exorbitant? Yes, but at least that valuation was positive. Today, the price-to-free cash flow ratio simply "does not compute." If you'll examine Netflix's most recent 10-Q, you'll see that the first two quarters of fiscal 2005 saw Netflix burn a total of $9.1 million in cash. Unless and until the company proves it can generate some real cash profits for its shareholders again, there's simply no reason to invest in this company.
Call me "Mr. Churn"
What's more, I expect Netflix's cash profitability situation to get worse over time, rather than better. And I'm the reason for it. As I've already admitted, I'm a devoted Netflix customer.
For three months a year.
That's right. When the networks stop broadcasting high-quality entertainment over those 500 cable channels, right around May of every year, I switch on the old Netflix subscription and catch up on all the "new" movies that I've let slide over the previous nine months that I was watching football, Sopranos, and those wacky doctors over on Scrubs.
But at the stroke of mid-September, as the airwaves spring back to life, I click the "cancel" box on my Netflix subscription, and for the next nine months it lies dormant. Revenue-less. Free cash flow-less. It's called churn. And it costs Netflix money.
Where's your added value?
But wait. It gets worse. During those three months that I am doling out my cash to Netflix, I've begun to notice something. Every week, I scan Netflix's site and check out what new releases have become available on DVD. But no sooner do I add a movie to my "queue" than I see it's showing on HBO (or Showtime, or Cinemax) in just a few days -- for "free." (I am, after all, still paying the cable bill).
If you assume that most Netflix subscribers are also cable subscribers, they, too, must ultimately realize that Netflix offers them little more than the chance to pay twice to see a movie that will be broadcast "free" on cable shortly. And what happens then?
Churn baby, churn.
Wait! You're not done. This is just a quarter of the Duel! Don't miss Rick Munarriz's bullish response, Rich's bearish rebuttal, or Rick's final word. When you're done, you're still not done. You can vote and let us know who you think won this Duel.
Netflix, Amazon.com, and TiVo are Motley Fool Stock Advisor picks.
Fool contributor Rich Smith does not own, nor is he short, shares of any company named above. If he did (or was), The Motley Fool would require him to tell you so. We're sticklers about things like that.
