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MKArch (99.66)

Why NFLX is the new AOL

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February 11, 2011 – Comments (9) | RELATED TICKERS: NFLX

Whitney Tilson might have thrown in the towel but MKArch isn't ready to. At least in CAPS anyway. Personally I don't understand how nobody noticed the *ONLY* reason Q4 didn't miss expectations and earnings decline sequentially for the second straight quarter was due to slashing their marketing expense and a mysterious plunge in their tax rate q/q. Keep marketing and the tax rate the same q/q and they earn ~$0.66 a nickel miss and down sequentially.

 I played with some numbers and I suppose if they keep adding 3M subs a quarter they will overcome the content cost increases that would have did in this quarter if Hastings hadn't manipulated the big beat. That's where the AOL comp comes in though. Intuitively I just can't believe the subs they are signing up in droves lately are going to be around long and I think I can explain why they won't be around long.

To understand NFLX fatal flaw you have to compare what they are paying for content to what the cable companies pay. It turns out that Comcast reports 23M video subscribers in their latest Q or just about the same as NFLX. If you annualize their programming costs it's about $7,200M for those 23M subs. NFLX reported ~$900M cost of subscriptions in 2009. I think ~$600M of that was for dvd's leaving ~$300M for content (the exact number isn't important). They have already signed two major new content deals in 2010 with Epix and Disney reportedly valued ~$200M/ year each and the Starz renewal this year is estimated to cost them another ~$200M or so per year. So add the new ~$600M to last years ~$300M and you get ~$900M or so in content costs for NFLX 23M subs vs. ~$7,000M for Comcasts same 23M subs.

 Even though Comcast is the largest cable company they are still just one of many that can't afford to have NFLX stealing subs from them. If you follow NFLX you no doubt have heard the rumblings about them not paying enough for content. But they have 23M and rapidly growing subs so the content providers have to respect them right? This is the fatal flaw in the bulls argument IMHO. While NFLX did a great job catching the industry asleep at the wheel which enabled their meteoric rise I don't think their model is sustainable because the content providers can't afford to let them undercut their bread and butter Cable and TV stations.

Here's the basic problem. The cable companies are already telling the content providers they are not happy watching NFLX undercut them with the cheap as dirt content they got while everyone was napping and they will demand similar or better rates for themselves. The content providers can't let NFLX set a precedent that will devalue their content in negotiations with their bread and butter cable and tv stations customers. Ultimately NFLX is either going to have to settle for cheap content that consists of stuff no one really wants to watch or pay prices for good content that will force them to have to charge on par with the cable companies.

Starz is a great example. One of the best reasons given for NFLX success so far is you can get Starz content from NFLX for a fraction of what it costs to get it from your cable company. You don't have to be a rocket scientist to see the cable companies telling Starz to stick their content where the sun don't shine if they don't get the same or a better deal that NFLX got. So do the content providers give everyone else the NFLX rate or tell NFLX to open up the wallet? I don't think the biggest cable companies will be satisfied with just the same deal they'll demand better and will probably get it.

But let's switch gears for a minute and look at all of this from the subscribers perspective. Right now they think they've beat the system getting Starz content for less than they'd pay a cable company plus a hodgepodge of old movies and tv re-runs all for only $8.00/ month. Not only that but this is just the beginning NFLX is adding more content (which looks to be mostly tv re-runs). What happens when STARZ tells NFLX they have to pay a price that will force them to charge the same $10 or $15/ month that the cable companies are charging? If NFLX balks what do they have left to offer their subs? An odd assortment of ancient movies and tv re-runs? I don't see how this doesn't end up with either NFLX being forced to charge a lot more for their service on par or likely more than the cable companies are paying for the same content or they are left with cheap content that no one wants to watch. Or at least will get bored with after a year or two.

Sure they are signing tons of subs with their first mover caught the big boys napping advantage but how do they keep these subs for more than a year or two? Maybe that's why NFLX will no longer be issuing standard subscriber statistics after 2011? My guess is even though churn seems fairly low right now they are seeing large numbers of the earliest subs walking away. Since their numbers are being dwarfed by the avalanche of new subs lately the over all churn rate is low but when today's subs start anniversarying over the next year or two look out. AOL was a first mover with phenomenal growth so much so they conned Time Warner into merging with them and the Street lapped it all up. In the end their model was killed by the cable companies. Sound familiar?

9 Comments – Post Your Own

#1) On February 11, 2011 at 11:17 PM, JakilaTheHun (99.93) wrote:

Good arguments, though, I'd disagree with a few of them. 

The thing that separates AOL and NFLX is that AOL was always hated.  Same deal with Blockbuster.  Same deal with MySpace.  These were all businesses that we used begrudingly.  AOL was cheap; Blockbuster had the best selection; MySpace had all the users.  But we really hated all of those businesses as consumers, so when something better came along, we dumped them in a heartbeat.

I don't think people hate NFLX.  I think people love their NFLX subscription.  So that's probably NFLX's biggest advantage. 

 

But I agree with you on the content costs.  In fact, I don't think Tilson was wrong about that issue.  The only problem was that he shorted a stock that he should've never shorted.  I admittedly bought some puts on it, but puts allow me to sleep at night.  I can't lose more than 100% and if I'm right, I might make 200% - 300%.  I don't have to worry about things going parabolic.  Going short on a momentum stock like this is not necessarily wise, even if the case against them makes sense. 

But as you mention, the content costs are key.  And even more than the cable companies, it's the providers that are likely to revolt.  They know that if they give NFLX too much power, they are going to be at NFLX's mercy, which is precisely what they don't want.  So they have an incentive to undermine NFLX's business model. 

So the question is, who will give in first?  Will NFLX raise prices in order to acquire more content or will the content providers lower prices to allow NFLX's $9.99 plan to continue. 

The other dynamic here is that so long as NFLX's customer base continues to grow, the economics behind this can be distorted.  That's essentially what happened with the Starz deal.  If Starz realized that NFLX would have as many subscribers as they do today, they'd almost certainly have demanded more money. 

My comparison is that it's almost as if NFLX were in NY real estate market and they somehow acquired NY properties at 1947 prices and fast-forwarded to 2011 in two years.  Basically,none of the content providers expected such rapid growth, so they were essentially pricing based on metrics that would be archaic two years later. 

The other wild card is international growth.  They can probably sell this to the UK and Australia fairly easily.  Where else can they go?  Will Indians buy this?  Can they build a model for non-English speakers? I'm not really sure about any of that. 

 

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#2) On February 11, 2011 at 11:59 PM, JakilaTheHun (99.93) wrote:

As far as the tax issue, it looks like they paid about 35%, which is the US corporate tax rate.  If they paid more in the past, it's possibly due to the differences in tax accounting vs. financial accounting.  Or it's possible that they are bad at tax planning. But I see nothing to suggest that they are 'manipulating' anything.

Historically, it looks like they've paid around 39% of income in taxes.  For Q4, they were around 35% - 36%.  That's not a dramatic drop. 

Any time a company can dramatically increase customers, while lowering marketing, I would say that's a good thing.  That doesn't happen often. 

 

It's really difficult to argue that NFLX has a bad business model.  It's an outstanding business model.  It's just priced based on very unrealistic expectations for growth. 

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#3) On February 12, 2011 at 12:01 AM, DJoshuaRubin (97.99) wrote:

I applaud your excellent and provocative title. A good title grabs enough interest to bring in eyeballs and you got mine. I think this should be a series. Here's some suggestions for future blog post headlines that might be cool and equally valid: 

Why Whole Foods is the Next Stop N Shop

Why Southwest is the Next Crazy Eddie's

Why the Green Bay Packers are the Next Hartford Whalers 

Why Disney is the Next Pep Boys: Manny, Moe and Jack

Why Jimmy Buffett is the Next Warren Buffett

Why Fruit Loops is the Next Kaboom! 


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#4) On February 12, 2011 at 12:13 AM, JakilaTheHun (99.93) wrote:

MK,

Sorry to keep commenting, but your post has really got my mind going. :)

While I said that lowering marketing was good and the tax thing isn't a big deal; I can see where you were coming from on that now.  Actually, I would just state it in another way. 

It's not that huge of a thing that those items decreased.  But it is a huge deal that their gross profit declined from about 34.4% from 37.7%.  That's a huge drop and absolutely suggests that the cost pressures are already sneaking in.  Those pressures are being ignored largely because of the massive subscriber growth.

 

This might be re-affirming part of my own thesis --- that their costs are switching from fixed costs to variable costs.  This looks good when there's little competition, but higher variable costs also open up the playing field to more intense competition, because the economies of scale are much less. 

 

What it should also suggest is that their margins aren't going to rise in the future.  They are going to have to increase earnings by increasing revenue growth.  They've done an excellent job at that, but with a 20M penetration in the US and Canada, they've already got about 15% - 20% of households.  So the only way they can grow revenues is to go international, where things become trickier. 

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#5) On February 12, 2011 at 8:44 AM, MKArch (99.66) wrote:

You can comment any time you want Jakila you are one of my favorite members and I've learned a lot reading your posts. I think your last post hit on why I brought up slashing marketing and the tax rate. Gross profit was actually down sequentially, the only reason they didn't miss on earnings and they didn't decline sequentially was because they slashed marketing and the tax rate dropped from something like ~42% to ~37%.

I agree the fact they could afford to slash marketing and still have massive customer growth (for now) is a good thing but to justify their current valuation they need sustained earnings growth and cutting operating expenses and their tax rate is not a sustainable way to grow earnings. I was thinking the same thing about them already counting 20% or so of U.S. households as subs and realistically what other countries out there have the potential to keep the growth going to maybe justify the valuation?

I don't really remember AOL being hated, I just remember it being fine when the internet was first being introduced to the masses and it was good enough at the time. The parallel I see with NFLX is even their most avid fans will admit their primary appeal is just being a bargain. That might be O.K. if the Starz content they sell somehow didn't come at the cost of the cable companies selling Starz subscriptions. That doesn't seem to be the case and the cable companies have made it clear they're going to demand the same deal NFLX gets if this doesn't end.

Reading some quotes lately it sounds like the answer is going to be NFLX pays a lot more money to Starz for a lot less content than they got in the last deal. Just going by memory from looking at Comcast I think their programming costs were about half of their video revenue for ~50% gross margin. I searched Starz on Comcast and saw an special 6 months for $10.00/ month. I figure it maybe $12.00-$15.00 per month normalized. So I ballpark cost at $6.00/ month and come up with a total cost of ~$1.7B/ year for 23M Starz subs at Comcast rates. Reports I've seen put Starz renewal at ~$300M. Unless I made a mistake in my ballpark above (which is entirely possible) NFLX is not going to get the same STARZ programming Comcast gets but some version of Starz light. In fact I've seen a quote from someone at Starz mentioning if NFLX wants cheap content they'll just get less of it.

So from what I can see the content providers are struggling right now to figure out what they can sell to NFLX that won't result in their cable customers losing subs to their premium content. It looks like a hodgepodge of old movies and tv re-runs and maybe a smattering of lower quality new content. How long will that keep subs renewing? Like AOL it's a great pioneer product but is it built to last? I don't think so. In fact Comcast is already offering some sort of tv on demand on all formats that looks to be a competitor to NFLX re-runs.

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#6) On February 12, 2011 at 9:07 AM, MKArch (99.66) wrote:

Hollywood Dan,

 I'm probably not going to win any essay contest anytime soon and I can see how my AOL point may have gotten lost in my long winded post but the point I was trying to make is that AOL experienced super high growth due to their first mover advantage and at the time the street loved their story. So much so that they were able to con Time Warner into merging with them. I see NFLX in a similar situation right now, super high growth due to a first mover advantage that I don't think is sustainable (even if the street doesn't agree with me right now).

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#7) On February 12, 2011 at 10:04 AM, MKArch (99.66) wrote:

Jakila,

One last thought on Hastings manipulation. I was putting the way he beat earnings in what I think is a wider context of a creepy conference call where analyst had to email their questions in and the moderator asked them. You can add to that the fact Hasting bothered to respond to Tilson's article instead of just letting results speak for themselves. Then you have the fact they will no longer issue standard subscriber statistics after 2011. I guess issuing 2011 guidance is a toss up they probably get it wrong but some argue they could at least ballpark a range. All together I get a picture of someone who feel compelled to control the message and sees sub problems coming in 2012. I also believe Hastings has sold every share of NFLX he's ever owned. He seems to be cashing in while the cashing in is good. Did the CFO really resign because he's looking for a CEO job? Why not stay on and leave when he's actually offered a job? Maybe I'm just imagining a conspiracy here but I get the sense managment is worried about something.

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#8) On February 13, 2011 at 5:12 PM, checklist34 (99.79) wrote:

jakilla, thats a TERRIFIC point about people liking nflx while htey really, truly, did hate blockbuster back int he dya. 

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#9) On February 14, 2011 at 11:42 AM, TheLastYetti21 (32.40) wrote:

MkArch,

"You can add to that the fact Hasting bothered to respond to Tilson's article instead of just letting results speak for themselves. Then you have the fact they will no longer issue standard subscriber statistics after 2011."

You are not just imagnining a conspiracy IMHO, I came to the same conclusions. I found it very odd that the CEO thought he had to response to an stock opinion blog. Why not just let your earnings report do the talking. Also he appears to be cashing out options as quickly as possible when looking at SEC filings. I am very skeptical of this company and their cash flow. Yet it is adored by analysts and wall street.

Its trading at a rediculous valuation and seems impervious to any bad news such as rising costs, dropping margins, and increasing compeition. I am not outright shorting the stock, but do have some puts. I believe the stock is being somewhat manipulated by big money, but the facts will eventually surface..... I hope :)

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