Description

Netflix (short idea) is a controversial stock that has attracted a fair amount of attention. As a result, I won’t repeat the full story, but will hit some highlights/lowlights and hopefully some issues that haven’t been well explored by analysts and the media. To answer a question that I’m sure will be asked: yes, the stock is heavily shorted; however, options are available.

I. Stock Market Valuation

Netflix has 23 million shares outstanding, giving it an equity value of about $500 million. However, adding in warrants and options that are mostly exercisable at very low prices, fully diluted shares are approximately 33 million. The total value is therefore $725 million, or $615 million net of cash.

The net valuation might not appear too extreme at 2.3 times the mid-point of Netflix’s $255-275 million revenue guidance for this year. However, the stock is trading at a very rich 81 times consensus 2003 pro forma earnings and 37 times consensus 2004 pro forma earnings. As usual, pro forma reporting gives a big boost. In the first quarter of this year, pro forma results were breakeven while GAAP results showed a loss of $4.5 million.

II. Customer Metrics and Valuation

Netflix releases a significant amount of customer data in an effort to demonstrate how well its business model is working. However, Netflix attempts to give a much better impression of customer performance than I believe is reality. In particular, Netflix focuses investors on its “non-GAAP estimated subscriber lifetime value” (also called “lifetime EBITDA) and brags that this measure improved in the first quarter “to an estimated $102 per subscriber from $82 in the prior year.” Setting aside a number of more minor quibbles that I have with Netflix’s methodology, I believe the key problems are as follows:

a. In calculating lifetime value, Netflix ignores the cost of the DVD’s that it rents to its customers. DVD purchases are capitalized and then amortized and the amortization expense is excluded from “lifetime EBITDA.” Deducting the rather obvious expense of providing DVD’s to customers who rent DVD’s, the lifetime values in the March 2002 and March 2003 quarters would be $56 and $61, respectively, 32% and 40% lower than the reported figures.

b. Netflix reports monthly “churn” rates that are staggeringly high, though improving. In the latest quarter, monthly churn was reported at 5.8%, down from 7.2% a year ago. These figures would be problematic for any subscription-based business, but they also appear to be significantly understated.

Netflix calculates its churn by dividing the number of customers lost in a quarter by the sum of the number of customers at the start of the quarter and the number of customers added during the quarter. This percentage is then divided by three to get a monthly figure. This results in a lower reported churn rate because the denominator includes a growing number of new customers who have had little or no opportunity to cancel as of yet. A simple alternative approach divides the number of lost customers by the average number of customers during the quarter (add beginning and ending customers and divide by two). This approach yields a monthly churn rate of 7.8% in the latest quarter, an improvement from 10.4% a year ago. I have tried a number of other, more complicated approaches to estimate the true month-by-month churn rates and they all indicate that the 7.8% and 10.4% figures are in the right ballpark – and are much more realistic than Netflix’s estimates.

The significance of this higher churn rate is at least two-fold. First, it means that Netfix must run faster to stay in place or get ahead. In this context, it’s not surprising that customer acquisition cost rose from $25 a year ago to $32 in the latest quarter – Netflix has to continue spending large amounts of money to replace the large number of customers who are canceling. Second, the higher churn rates again decrease lifetime customer value. Adjusting for both the DVD costs as described above and the higher calculated churn rates, Netflix’s lifetime customer value methodology would yield values of $31 and $38 in the March 2002 and March 2003 quarters, far less than the $82 and $102 reported.

If Netflix’s value was based solely on its customer base, the business might be worth $74 million today, 12% of the current $615 million net enterprise value. In this case, I’m valuing each customer at $70, since the $32 per customer marketing expense has already been incurred. This approach gives Netflix no credit for future growth, but it does gives it the benefit of assuming that each customer is a brand new customer with 100% of its expected economic life ahead of it, which of course is not accurate.

Looking ahead, let’s optimistically assume that Netflix can nearly double the number of customers to 2 million by the end of 2004. This is a higher number than analysts are generally expecting, but still yields a total customer value of only $140 million (assuming no change in per customer value). Between options exercises and free cash flow, Netflix might have $200 million in cash by year-end 2004, but the value of its customers plus cash under these assumptions would still be less than half of the current $725 million stock market value.

III. Other Issues

a. Declining Gross Margins – Netflix’s gross margin declined from 50.3% in the March 2002 quarter to 46.1% in the March 2003 quarter and management is now guiding to 42-44% for the balance of 2003. Ironically, as Netflix improves its service and attracts more loyal customers, its costs go up. The number of DVD’s rented per customer increased 15% in the first quarter of 2003, but Netflix got no incremental revenue because its service is fixed-price.

b. Competition – Blockbuster, Wal-Mart, and several other competitors are already in this field, though Netflix has a commanding market share lead. Netflix’s stock dipped last week as Blockbuster indicated that it may intensify its efforts. Other companies such as Hollywood Video may well enter this arena and Netflix may find itself at a disadvantage unless it forms a partnership that can give it a bricks-and-clicks presence as well as the buying power of a larger DVD purchaser/renter.">">

Catalyst

1. A revenue or earnings “miss.”

2. Increased insider selling and/or increased float resulting from stock option and warrant exercises.

3. Heightened valuation concerns if larger competitors increase their marketing efforts.">