Netflix Stock a Real 'House of Cards'

02/06/2013 10:30 am EST


John Heinzl

Reporter and Columnist,

Rising debt, soaring costs, increasing competititon, and yet the stock defies gravity...we've seen this movie before, writes John Heinzl, reporter and columnist for Globe Investor.

It’s official: Wall Street has taken leave of its senses. That’s the only plausible explanation I can come up with for the ridiculous valuation of Netflix (NFLX), a company whose future remains as murky as ever despite a massive run-up in the stock following a modest fourth-quarter profit.

We’ve all heard the bullish arguments for Netflix: It’s a market leader in video streaming; it has a strong brand name; its subscriber base is growing as more consumers cut their cable and watch Netflix on their tablets and Internet TVs for $8 a month.

But that doesn’t change the fact that Netflix is an insanely expensive and risky stock, given how its programming costs are soaring just as competition from Amazon (AMZN), Verizon (VZ), and other deep-pocketed players is heating up. It’s fitting that Netflix titled its new original series House of Cards, because that’s exactly how some analysts describe the company.

“We remain dumbfounded at the value placed by investors on Netflix shares,” Wedbush Securities analyst Michael Pachter wrote in a recent note.

Having roughly tripled over the past four months, Netflix shares now trades at about $174—or about 150 times the average 2013 earnings estimate of $1.14 a share. This implies that investors are expecting torrid profit growth in the years ahead.

Good luck with that.

Pachter thinks the shares are actually worth about $55, and he calls that target “generous.” He’s far from the only bearish analyst on Wall Street: At least ten others have price targets of less than $100.

So why do the shares continue to defy gravity? Because investors don’t understand that Netflix’s business model is fundamentally flawed.

For starters, the company’s program costs are soaring. To win new subscribers and prevent existing ones from switching to competing services, Netflix has to offer compelling content, but that costs money—big money. Pachter estimates that the cost of Netflix’s streaming content deals will increase to nearly $2.5 billion in 2013, up from about $2.2 billion in 2012 and less than $300 million in 2010.

Recent multi-year agreements with Disney (DIS) and Warner Bros. (TWX) alone will cost Netflix an estimated $320 million in 2013, and the price tag on those deals is expected to grow in coming years. Then there are the costs for original shows such as House of Cards, a new season of Arrested Development coming this spring, and a handful of other in-house programs expected this year.

As its content costs balloon, Netflix faces some hard choices: It can cut existing programs to save money; it can issue more debt; or it can raise its subscription prices. The last option would probably not go over well given the revolt when Netflix raised prices a couple of years ago, so for now the company is focusing on the first two.

Last year, Netflix lost access to new Sony and Disney movies when its deal with Starz expired (under the new Disney deal, new movies will not be available until 2016). Recently, Netflix also lost an estimated 800 hours of programming that included A&E and History Channel content. Given how quickly Netflix’s costs are rising, Pachter believes Netflix might also cut a portion of its content from CBS, Fox, or NBC Universal this year to save money.

The problem with slashing programs is that subscribers might cancel their Netflix service and take their eyeballs—and wallets—somewhere else, such as Amazon, Redbox Instant by Verizon, or another streaming service.

Indeed, a big risk for Netflix is that streaming video has low barriers to entry, which means competition is only going to increase. At the same time, customers can switch easily from one service to the other with a few mouse clicks.

As Netflix’s content costs are rising, so are its debt levels—to the point that credit rating agencies are expressing concern. In late January, days after its fourth-quarter results came out, Netflix announced an offering of $500 million of notes at 5.375%. About $225 million will be used to refinance existing debt and the remainder is for capital expenditures, investments, and “potential acquisitions and strategic transactions,” Netflix said.

Netflix’s credit rating of BB- was already below investment grade, and after the new issue Standard & Poor’s revised its outlook to negative “based on an increase in debt leverage as well as our expectation for negative discretionary cash flow in 2013 and possibly into the first half of 2014, resulting from increased investments in original programming.”

Original content “requires more upfront payments and the return on investment can be highly uncertain,” S&P said. The strategy, combined with rising costs for third-party content and losses associated with Netflix’s international expansion, “raises business and financial risk, and will likely consume liquidity at least over the near term,” it said.

Even as Netflix reported a modest profit of $17.2 million, or 29 cents a share, on revenue of $3.61 billion for the year ended December 31, the company posted negative free cash flow of $20 million and $51 million in the third and fourth quarters, respectively, more than wiping out the positive free cash totaling $13 million in the first and second quarters.

In his January 23 investor letter, Netflix CEO Reed Hastings warned that free cash flow will be “materially more negative” in the first quarter compared with the fourth quarter, as the company makes the “bulk of our remaining cash payments for our current originals.” In subsequent quarters, free cash flow will “improve substantially,” he said.

Pachter is skeptical. “Notwithstanding the company’s apparent return to profitability, free cash flow remains elusive, as escalating content costs...exceed the profits derived from the business. We think that this tradeoff will continue indefinitely,” he wrote.

What’s more, he believes that Netflix’s accounting vastly overstates the profitability of Netflix’s domestic streaming operations, which are critical to the company’s future.

According to Netflix, domestic streaming had “contribution profit”—revenues less the cost of revenues and marketing expenses—of about $350 million in 2012, compared with contribution profit of about $539 million for Netflix’s DVD-by-mail division. DVDs were Netflix’s original business and remain its cash cow, even though the number of DVD subscribers is falling steadily, down 27% last year.

However, if one includes unallocated “other operating expenses”—general, administrative, and technology spending—according to their true impact on each of Netflix’s divisions, domestic streaming generated operating profit of just $50 million in 2012, Pachter estimates, making it pale next to the DVD business’s estimated operating profit of $450.4 million.

“The company’s lack of concern about declining DVD subscribers is baffling, and management optimism about contribution profit from domestic streaming growth is misguided, in our view,” he wrote.

Given Wall Street’s love of “story” stocks and its habit of ignoring valuations, it’s possible the shares could continue rising. Indeed, short sellers who were betting heavily against the company were forced to cover their positions after fourth-quarter numbers surprised on the upside, and the massive short squeeze undoubtedly drove the stock even higher.

But make no mistake: This movie will not end well.

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