Bearish On Netflix

By Arthur Pinkasovitch | February 16, 2011 AAA

Investors in Netflix (Nasdaq:NFLX), the streaming and mail order movie rental company, have realized tremendous gains, as the stock has surged over 500% in the past two years, with most of that growth coming in 2010. Even year-to-date, shares have risen by 35%. In 2010, Netflix surpassed the 20-million subscriber mark as 3.08 million additional users started using the convenient movie service. As Netflix continues to see growth in the domestic and international market, with Canadian operations becoming a significant part of the business, the stock keeps on defying market expectations and keeps setting new record highs.
However, concerns regarding the company's ability to sustain required levels of growth, and even issues with accounting practices regarding the amortization of its content library, have recently surfaced. With Amazon (Nasdaq:AMZN) expected to launch a free prime user service within the next couple of month, Netflix will be negatively affected in two main ways.

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Higher Expenses
First, there is practically no real competition for content streaming. Although other competitors, such as Apple (Nasdaq:AAPL), offer Apple TV, Netflix is able to offer movies for a much cheaper price. With Amazon entering the market as a direct competitor, a bidding war over premium content is likely to squeeze Netflix's margins. Even if Amazon remained out of the market, it seems highly unlikely that content providers such as Starz will renew contracts at the previously established low prices.

Estimates suggest that Netflix is paying Starz approximately $30 million a year for content rights. With this contract set to expire in 2011, Value Line predicts that the new agreement will be renegotiated for $250 million per year. Netflix would have to increase revenues by 13% to compensate for this price hike alone, ceteris paribus. Management released a forecast of future operating margins of around 14%, slightly better than the average annual operating margin of 13.1% in 2010. Based on increased competition for quality contracts and higher costs of international expansion, these forecasts seem overly optimistic.

Competition for Subscribers
Secondly, the obvious impact of Amazon's move service is that it will either hinder Netflix's growth, or might even attract their current customers. With a continuous quarterly Netflix churn rate of approximately 4%, there is obviously some dissatisfaction with the service which Amazon will be able to capitalize on. Prime members will have an automatic incentive to cancel their Netflix accounts since Amazon will be offering the service for free. Although Amazon will initially have a smaller library than that offered by Netflix, with nearly $4 billion in cash and strong brand recognition, Amazon has the necessary resources to grow the movie streaming business.

In addition to Amazon, other potential serious future competitors in this space may include Google (Nasdaq:GOOG), Comcast (Nasdaq:CMCSA), News Corp (Nasdaq:NWSA) and Time Warner Cable (NYSE:TWC).

Financial Performance
Netflix has also come under criticism for understating amortization. The company amortizes "licensed streaming content on a straight-line basis generally over the term of the related license agreements or the title's window of availability". Potentially, a more accurate method would be to amortize content on an accelerated basis, since newer material is more likely to be watched shortly following its release. Such a practice would likely decrease stated net income. Other concerns stem from the fact that, despite strong revenue and earnings growth, cash flow from operations declined by 15% in 2010 and Q4 was the first quarter in the past two years when Netflix did not perform any share buybacks.

The Bottom Line
The impact of these issues, including the threat of entrant into the market, will be determined in subsequent quarters. (Discover how to keep score of companies to increase your chances of choosing a winner. See What You Need To Know About Financial Statements.)

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