Don’t Be Fooled by Netflix Earnings Report

The earnings report from Netflix (Nasdaq: NFLX) came as a bit of a surprise to myself and a few other investors, as top line numbers were impressive.  Yet overall earnings and cash flow remain unimpressive.
The overall Netflix earnings report was pretty impressive.  U.S. streaming video subscribers increased by 2.25 million to 35.7 million.  Meanwhile, international membership grew by 1.75 million to a total of 12.7 million, and now represents 25% of the company’s total streaming revenue.  The DVD business continues to slowly die out, with 6.65 million active memberships, down from 7.98 million one year ago.
Those results were enough to send Netflix shares jumping $25 or 7% following Monday’s earnings announcement.
In addition to the Netflix earnings report, the company also revealed some interesting news.
Netflix is raising its prices. The company’s current streaming video service costs $7.99 per month. And the price hasn’t been changed since 2010 when Netflix first introduced streaming video.
The company will raise rates by $1 or $2 per month for new subscribers. And eventually, existing subscribers will be expected to pay more too.
The simple fact is that Netflix has been making huge investment in content. With original programming of House of Cards costing $100 million, Netflix is attempting to be the Internet’s premier provider of video content.
Historically, Netflix has made a lot more money from its DVD rental business than streaming video.  DVD contribution profit was $97 million in the first quarter, meaning each subscriber was worth about $14.66.  Domestic streaming profit contribution was $201 million, meaning each subscriber was only worth $5.64.
With the margins on streaming video subscribers roughly 38% the amount of DVD subscribers, it’s clear that more price increases are coming.
For the first quarter, Netflix’s operating income tripled to $97.6 million, but free cash flow was a mere $8 million.
As a result, the company had to issue another $400 million in debt to fund its original programming. Netflix is fond of touting its original programming, yet it’s unclear how these shows contribute to the company’s bottom line.
Netflix investors should be concerned for several reasons: mounting off-balance sheet content obligations (now some $7 billion), only $1.66 billion in cash, virtually no free cash flow, and debt raised for original content.
There is simply no way Netflix can meet those content obligations. Now, that hardly means the company will cease to obtain programming.  However, the studios see Netflix as a vampire sees blood.  The studios will simply renegotiate content deals with Netflix in order to suck it dry of any free cash it ever has.  If Netflix can’t make good on content it is being exclusively provided, the studios will sell it to someone else, like Amazon (NASDAQ:AMZN) or Apple (NASDAQ:AAPL).
That’s why Netflix is raising debt for original programming. Rather than feed the studios every last dime it has, it instead raises money for programming it owns…to sell to other distributors after Netflix is finished with the content.  Netflix sees more ROI on making an investment in content it owns then in renting the content of others.  Unfortunately, a small slate of TV shows won’t keep it afloat.  It must still license other content in perpetuity.
All the while, Netflix will have to continue ratcheting up subscriber fees, little by little. It will never have much free cash flow as it meets content obligation payments.  The very best Netflix can hope for is that it reaches some maximum number of subscribers that throw off enough cash to maintain certain amounts of content, while possibly making money by selling the content it produces to other parties, also to purchase content. So while investors may see growth in operating income as subscriber base and fees expand, it will never see sustainable free cash flow.  That makes the stock worth very little in the long run.
Amidst all of this, the company must deal with competition.  Wouldn’t you know it – Amazon just announced with deal with Time Warner’s (TWX) subsidiary HBO.  Prime customers can now get HBO content via streaming video.
So there is simply no way to justify Netflix’s $353 price tag, which represents a 84x multiple.  That, however, does not mean the stock can’t go higher.  When it comes to a momentum stock that few investors truly understand, anything can happen.
Lawrence Meyers does not own shares in any company mentioned.


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