The comments by Netflix Inc.’s (NFLX) CEO Reed Hastings at the UBS media conference summarized the company’s current scenario and pointed out where it went wrong. During the conference, Hastings quoted “We did so many difficult things this year that we got overconfident," and added,"Our big obsession for the year was streaming, the idea that 'let's not die with DVDs”.
However, discounting the threat from online streaming competitors like Verizon Communications Inc. (VZ) and Amazon.com Inc. (AMZN), Netflix recognized HBO Go, a Time Warner Inc. (TWX) streaming company, as its worthy adversary. Mr. Hastings stressed on the fact that the future of the company lay in the streaming business.
HBO Go has a wide variety of content that it can leverage in gaining traction in the online streaming business. Moreover, like Netflix, the service is made available for Apple Inc. (AAPL) devices and also for Andriod-based smartphones.
The developments at Netflix over the past few months can be best summed up as “How best to ruin a company” or rather, a company that promised robust growth prospects. Netflix, at its helm, was adding subscribers every quarter until it resorted to a price hike of 60% for its services in July 2011. Since then the company has been reeling under pressure, as it witnessed an exodus of subscribers (800,000 U.S. subscribers to be exact) in the recently concluded third quarter.
Moreover, the company had decided to separate the two services of streaming and DVD by mail and form Qwikster, a new company for the latter. However, in a complete reversal of their decision, management scrapped the proposed separation. The turn of events was reason enough to confuse both analysts and investors. Thus, by the time management scrapped the idea of splitting the company into two, the damage had already been done in terms of investor sentiment and stock prices. Netflix’s market value had dropped from $16 billion to $3.77 billion in a space of just 5 months.
To further sour the mood, management provided a dismal outlook for the current quarter and fiscal 2012. Though the company expected to remain profitable on a global basis, it acknowledged that the exodus of subscribers in the domestic market would continue in the current quarter, though at a slower rate.
To salvage the situation and get in the good books of its subscribers, Netflix signed a number of licensing deals with big Hollywood production houses to provide varied content. But the deals that are being signed come at a cost. If the company is not able to recover these costs from its customer base, it would spell serious headwinds for the company.
The major near-term challenge for the company is cost escalation in the form of license and renewal fees. Analysts predict that the company will have to shell out $2 billion in terms of licensing fees to content providers in 2012, escalating from $180 million in 2010. Netflix said in a regulatory filing that it has impending payments of more than $3.5 billion over the next few years that is to be paid for the content under contract. To keep the company afloat, Netflix has to bank on subscriber growth, both domestic and international.
Moreover, the company is raising $400 million in cash through stock offerings at $70 per share and convertible bonds. This seems to be a desperate move on the company’s part to expand its footprint in the international market, to primarily compensate for the massive subscriber churn in the domestic market.
We believe that the proceeds from the transaction would also help Netflix to develop its streaming library, particularly in its domestic market, which will attract new subscribers going forward. However, an increasing debt level remains a concern, in our view. As of September 30, 2011, Netflix had cash and cash equivalents of $365.8 million, versus a long-term debt of $200.0 million.
Post its planned foray into the U.K. and Ireland in early 2012, the company has no further plans to expand in the international market. Expanding into newer regions tend to escalate costs in the form of technology investments and brand-building initiatives.
However, Netflix cannot completely do away with expansionary initiatives, which can be used to offset losses in the domestic market, caused by increasing competition. Also, if Netflix is able to enter a few nascent markets, it could enjoy a first mover advantage.
Netflix has already added Latin America and the Caribbean islands. However, the company has been facing competition from Telefonica SA’s TerraTV and Net Servicos de Comunicacao SA in Latin America. Further, Latin America’s lower income, limited broadband availability and limited use of credit cards are hurdles for Netflix’s business here. The latter is the biggest concern for Netflix, as the primary payment mode for subscriptions is credit cards.
Although Netflix expects to remain profitable on a global basis for the fourth quarter, we prefer to remain ‘Neutral’ on the stock and wait for significant developments.
We currently have a Zacks #3 Rank for Netflix Inc., which translates into a Hold rating in the short term.
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