Netflix - The devil in the details
Netflix is down 35% today as news of subscriber cancellations and looming losses hit the market. Some say that this is an overreaction while others state rather convincingly that the company is done.
To boot, Netflix's management which had grown well-regarded for their fast decision-making, the development of a logistics operation that was the envy of many and there can-do attitude seems to have committed a slate of blunders in 2011, some of which will be difficult to recover from:
1. Stock repurchases - Since Jan 2009, NFLX spent 734MM in stock repurchases with $200MM spent in 2011 alone at a time when the stock price was at its highest and Hollywood was looking to increase content acquisition costs related to movie content - poor signal to both the market and to partners.
>In 2009, the company spent it's entire cash generated from operations, to buy back shares. That figure fell to 79% in 2011, averaging 85% over 3 years. That is rather foolhardy for a growth business.
2. Price increases - by 60% in a recessionary environment, with declining consumer confidence and for a product that is not a necessity and one that is easily substitutable - really bad move.
>This not only led to net customer losses of 805,000 but hidden in the details is that actual losses, without netting out additions, rose by 56% QonQ from 3.5MM in Q2 to 5.5MM in Q3 with new additions declining 11% from 5.3MM in Q2 to 4.7MM in Q3.
3. Qwikster - On a scale of 1-10, where 10 is a really crappy decision, this was a 20. A lot customers loved the option of either streaming or ordering a DVD and splitting these two pretty much halved the value to the customer. Even though the decision was revoked three weeks later, the damage had been done.
This does not augur well for the company and I score the management on 2 out of a total mangement score of 5.
Now to the fundamentals:
a) As of Q3-2011, revenues are growing at 48.6%YoY while cost of subscription grew 61.4% YoY. Subscription costs have been growing faster than revenues snce Q4-2010 and this does not bode well for the company that's losing its client base.
b) Operating margins have weakened somewhat from 14.2% in Q1 to 11.8% in Q3 with Net Margins dropping to 7.6% in Q3 vs 8.4% in Q1.
c) There is a bit of short term liquidity concern seeing that cash from operations is down 57% from $116MM in Q1 to $49MM in Q3-2011. If this continues, then NFLX will have to dig deeper into its cash horde (standing at $365MM) to pay it's quickly accumulating accounts payables which are now at $750MM up 150% from $301MM in Q1.
d) International expansion will certainly eat into margins as the company ramps up its sales and operations teams in Europe and other locations. Wth a global economic slowdown, this is a bet that only time will tell.
All is not lost but speed is of the essence. Netflix will need to make a few quick decisions to stabilize its business:
1. Begin to wind down its share repurchase program - this is unnecessary.
2. Renegotiate Content Acquisition Costs with the studios and Starz and HBO back to the table.
3. Explore additonal TV rights for already run episodic content. Think though how to offer the customer more value for their money.
3. Manage their cost base.
Disclosure - No position in NFLX at this time.