Netflix Rule as No. 1 S&P Performer But…. negative free cash flow, a surge in liabilities for new movie and TV-show content and a long-term increase in unpaid subscribers

Netflix Rule as No. 1 S&P Performer But….

Netflix Inc. (NFLX) has become the best performing U.S. stock in the Standard & Poor’s 500 Index in 2013 and the second most expensive, and therein lies a tale of disagreement.

Investors who dig into company filings can find negative free cash flow, a surge in liabilities for new movie and TV-show content and a long-term increase in unpaid subscribers. Moreover, perceived limits on customer numbers and the high price of shares have led 26 of the 37 Bloomberg-listed analysts covering the stock to advise investors to sell or hold stakes.Most shareholders aren’t listening to talk about a bubble or other bad news. They love Netflix.

Michael Pachter, a managing director at Wedbush Securities Inc. in Los Angeles, says a lot of investors are dazzled by the growth potential of online businesses, such as Inc., a startup-turned-industry-giant that sold $16 billion of merchandise in the first quarter. As long as there is growth, these investors, “in a weird bubble of Internet stocks,” show little concern about the finances of online companies, he said.

“Netflix looks like Amazon to most investors,” said Pachter, who rates the No. 1 Internet video subscription service “underperform.”

Chief Executive Officer Reed Hastings may get questions about the Los Gatos-California-based company’s performance when he hosts a videoconference today to discuss second-quarter earnings. Hastings, 52, who owns about $690 million in Netflix stock, will also be in position to trumpet the success of the drama series, “House of Cards,” which received nine Emmy Award nominations last week, including best drama. It’s the first time an Internet streaming service has vied for these top entertainment honors. Netflix got 14 Emmy nominations in all.

Call Today

Fielding questions from fellow analysts on the call will be Richard Greenfield of BTIG LLC, which specializes in trading and services for hedge funds. He saw Netflix stock shoot past his April target of $250 and plans to reassess his projection after he hears the results today. One probable positive that’s already clear, he said: The Emmy nominations may encourage talented people to participate in Netflix’s “next big show.”

Investors who want to check if the naysayers have a point can start with a review of cautionary disclosures Netflix has made in regulatory filings and in correspondence with the U.S. Securities and Exchange Commission. As with most CEOs, such items aren’t the principal focus of Hastings’s popular accentuate-the-positive message in telling his company’s story.

Front and center in such an analysis is how much Netflix, with a market capitalization of almost $15 billion, spends on content. It pays about $500 million a quarter, while running a deficit in free cash flow in the past two quarters, company filings show.

Binding Contracts

It has $5.7 billion of binding contracts to pay for and license streaming content, of which about $2.4 billion is payable in less than a year, according to its first-quarter filing. Another $2.7 billion is due in one to three years.

In a December pact, Netflix probably agreed to pay more than $350 million a year for Walt Disney Co. movies, estimated Tony Wible, an analyst with Janney Montgomery Scott in Philadelphia. Netflix doesn’t disclose such details, spokesman Jonathan Friedland said.

Warner Bros. Television Group is another beneficiary of Netflix’s spending, providing such dramas as “Revolution.” Lionsgate Television produced one of Netflix’s original series, the prison comedy “Orange Is the New Black.” Netflix has a multiyear pact with Twentieth Century Fox Television to stream past seasons of “New Girl” and has agreed to buy shows from DreamWorks Animation SKG Inc. Netflix also offers HBO’s “Game of Thrones” on DVD.

Negative Cash

First-quarter free cash flow was “negative $42 million” because of spending for such shows, Hastings’s April letter to shareholders said. Pachter, whose unit is part of the financial services and investment firm, Wedbush Inc., said Netflix made a conscious decision to spend aggressively to buy new content even if that meant running out of cash.

“They’re financially fragile by choice,” he said. His concern: “If their cash flow continues negative they could have a problem.”

Netflix itself says the same in its last annual report: “To the extent subscriber and/or revenue growth do not meet our expectations, our liquidity and results of operations could be adversely affected as a result of content licensing commitments and accelerated payment requirements of certain licenses.”

Raising Prices

Netflix could handle content payments by raising prices to subscribers. Hastings has said he doesn’t favor that. No wonder. In 2011, Netflix announced it would separate its DVD-by-mail and streaming plans, with each available for $7.99 a month. Customers with joint streaming and DVDs plans saw bills jump to $15.99 from $9.99. After that 60 percent bump, about 800,000 subscribers canceled. The stock hit a low in November of that year of $63.86, down from a 2011 high of about $299. It’s still not back to that level.

If Hastings doesn’t budge on streaming prices, he might have to keep selling stock or debt. That wouldn’t be good for shareholders, Pachter said. In February, Netflix sold $500 million of junk bonds to help fund programming and retire debt.

Netflix also is adding business risks as it licenses more original series that don’t have a proven track record like the hit AMC “Mad Men” series it offers.

“There is always the chance any particular show could flop,” said an April report by New York-based Jefferies Group LLC, a securities and investment-banking firm. “Prior content deals offered a more predictable return profile.”

Internet TV

One of Hastings’s key messages to investors has been about that growth Pachter says Internet investors are focused on. The CEO says Netflix is “leading the way” toward “Internet TV,” a concept designed to rival cable.

Other key metrics in assessing the company include revenue, subscriber numbers and, in the long term, profit. Netflix revenue was $3.6 billion last year, up from $3.2 billion the year before.

Profit was $17.2 million in 2012, after rising annually since 2003. Profits peaked at $226.1 million in 2011. That drop in 2012 was partly because the company offered more free-trial subscriptions. Overseas that promotion resulted in a first-quarter loss of $11 per customer, according to company filings.

The profit trend improved in the first quarter. Net income of $2.7 million compared with a year-earlier loss of $4.6 million. For all of 2013, analysts tracked by Bloomberg estimate profit of $1.44 a share in profit, an increase from 2012’s 29 cents, according to data compiled by Bloomberg.

52-Week High

In the face of these results, the company’s stock reached a 52-week closing high of $267.92 on July 17 and now trades at 383 times 12-month profit, surpassed only by Alcoa Inc. in the S&P 500, data compiled by Bloomberg show. Its estimated price/earnings ratio for 2013 is 184. The P/E ratio for the S&P 500 Index is currently 16. Netflix’s 185 percent gain this year is the best in the S&P 500.

“The current valuation reflects unrealistic expectations across all major economic and strategic levers of the business,” Sanford C. Bernstein & Co. analyst Carlos Kirjner wrote in a June 25 report when he downgraded the stock to “underperform” with a price target of $180, about a third lower than what it closed at last week.

At the same time, Netflix has to deal with the perception that market forces may interfere with its customer-growth goals. Hastings has said he would like to get 60 million to 90 million U.S. customers, about two to three times HBO’s domestic total.

Limited Market

Here is how one skeptic sees that plan: Netflix’s potential market is the 45 million households that have broadband connections powerful enough to support Netflix’s streaming video products and to connect their TVs to the Internet today, Kirjner said in his June 25 report. That market may grow to 65 million in several years, and Netflix might eventually get as many as 43 million subscribers, he said. Mobile broadband will not support Netflix “at scale” when carriers place data caps, he said. In a July 15 report, Kirjner said his forecast of the potential market is “perhaps too generous.”

Netflix disagrees, saying customers can use a mobile device with WiFi. Its “addressable market” is 80 million U.S. households with some kind of broadband Internet access, according to spokesman Friedland.

There has been a debate too about Netflix subscriber numbers. Consider the April 22 report by Variety that Netflix had passed HBO in “total” U.S. subscribers. That report by the entertainment industry bible and other news organizations played a role in one of Netflix’s best stock moves: a 24 percent gain.

Unpaid Subscriptions

The reports didn’t mention that Netflix subscriber numbers included 1.3 million U.S. users who didn’t pay because of free trials, regulatory filings show. HBO is still the leader in paying U.S. subscribers, according to the SNL Kagan research firm. HBO had about 28.8 million U.S. subscribers in the first quarter, SNL Kagan estimated. Netflix had 27.9 million paying U.S. online subscribers, it said.

As of March 31, 5.7 percent of Netflix’s 36.3 million U.S. and international online members weren’t paying — 4.8 percent of online and DVD customers.

“The ebb and flow of free trials is directly tied to the number of markets we open each year,” Friedland said. “We have never said as a company that we passed HBO.”

Netflix may also find the audience goal for its product hits a wall, just as HBO has.

Customer Limit

“HBO has hovered at just under 30 million for several years,” SNL Kagan said in its tally of first-quarter numbers, referring to U.S. subscribers. “Showtime and Starz will continue to slow as they get closer to 30 million.”

Netflix will probably pass HBO in paid U.S. subscribers within the next two quarters, SNL Kagan predicted.

Netflix’s percentage of non-paying subscribers has grown in recent years with its emphasis on U.S. and overseas online streaming, though it’s down from last year. The 4.8 percent of Internet and DVD members who weren’t paying as of March 31 compares with 3.1 percent in 2009, before it began emphasizing its streaming service, company filings show. A year ago its percentage of non-paying Internet and DVD customers was 5.9 percent.

Netflix changed its written disclosures on paid membership after the SEC demanded it. The SEC, which polices information relayed to investors, asked Netflix in a June 27, 2012, letter what “differentiates” paid subscriptions from total subscriptions, and told it to disclose the answer in filings.

Subscriber Definition

Netflix answered in a July 25, 2012, letter that a subscription is the right to receive its services, after providing a method of payment. Netflix told the SEC that total subscribers included not only free trials and cancellations but also “payment holds” at that time — accounts Netflix couldn’t get authorization to charge.

Netflix, which later removed payment holds from the count, promised to define total subscribers in future filings. It did so — in footnotes. Its first-quarter report filed April 26 has such a footnote, which isn’t included in the shareholder letter announcing results.

Amazon, whose video service is a small part of the total company, doesn’t disclose subscriber numbers. It has fewer than 10 million U.S. customers, estimated Deana Myers, a senior analyst at SNL Kagan. Hulu, which isn’t publicly traded, disclosed more than 4 million paying U.S. subscribers in the first quarter, according to its website.

Resisting SEC

The SEC told Netflix in two letters last year that investors could benefit from knowing just how much the company was spending on content every quarter, considering “the magnitude of this cost component.” Netflix successfully resisted, arguing it wasn’t required by the rules to disclose and that investors would be hurt more than helped because competitors would benefit.

“A deeper understanding of our content acquisition costs would assist competitors in designing and implementing their content deals,” it wrote on Oct. 24, 2012.

Now, Netflix tells investors it spends $2 billion a year on content. SEC filings show it added $591.9 million to its content library in the first quarter, after spending $2.5 billion in 2012 and $2.3 billion in 2011.

Netflix’s total liabilities, recorded at $3.6 billion, would be at least $3.3 billion higher if all of its contractual obligations for content were on its balance sheet, based on data in its latest quarterly filing. Netflix said the $3.3 billion doesn’t have to be reflected on its balance sheet yet because it doesn’t meet criteria for asset recognition.

Confused Analysts

Disclosures by Netflix have sometimes confused analysts following the stock. Take “Netflix Originals,” a term the company uses for shows such as “House of Cards.” Though they premiere on Netflix, the company doesn’t own them and can’t make money from selling or licensing them to third parties.

Rival Amazon is now offering “House of Cards,” which is owned by Media Rights Capital, an independent film and television studio partly backed by Goldman Sachs Group Inc. It charges $1.99 an episode on its pay-per-view service. It also sells a DVD version.

Hastings, who told a 2011 UBS AG conference that he’s in an “arms race” with HBO to dominate Web-based TV viewing, is arguably running a different, less lucrative business from its designated rival’s pay-TV and production operation, which produced income of $1.6 billion last year. Netflix is technologically closer to Hulu LLC or Amazon’s online video service because it is accessed online on demand through computers or smartphones or by mail in DVD format.

Big Competition

Microsoft Corp., Google Inc., Apple Inc. or Comcast Corp. could start a successful competitor to Netflix, Bernstein analyst Kirjner said in his July 15 report.

“We believe the competitive threat is one of the greatest blind spots for Netflix investors,” he said.

One famous Netflix holder has had a happy experience with his investment. Sort of. Billionaire financier Carl Icahn made a $168.9 million bet on Netflix stock and options in October. His play: Microsoft, Amazon or Verizon Communications Inc. might be interested in buying Netflix amid a “great consolidation” coming to the business of streaming movies and TV shows.

Then he turned a little sour. He lambasted Netflix’s “poor governance” in November after it adopted a poison pill to deter such acquirers. He returned to the pro-Netflix camp after stock price increases this year produced a huge profit for him.

“When you make $600-$700 million, you don’t punch the CEO in the face,” Icahn, 77, told Bloomberg News in March.

To contact the reporter on this story: Linda Sandler in New York at

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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