Netflix: Rising Content Costs A Growing Concern

by Erica Thinesen

Netflix (NFLX) has reported its results for the second quarter and the results were not bad but the outlook for the future is far from reassuring. In fact, things are going to get tougher as Netflix discards its DVD business and moves towards a streaming only operation. Overall revenues were just above the middle of their guidance and in line with the expectations of equity analysts. Net revenues were $6 million on total revenues of $889 million. Earnings per share came in at $0.11 a share which was in excess of the consensus estimates of $0.05 despite the increase in the account of diluted shares by more than 3 million shares to 58.8 million shares. The guidance for the third quarter is revenues of $6 million to $8 million on total revenues of $890 million to $911 million and earnings per share of $0.10 to $.14 a share. However, the company announced that results for the third quarter will be affected by the Olympics as most people will spend time watching the games and not spend as much time watching Netflix. The company also announced that they will return to a loss in the fourth quarter because they are planning to enter a new European market.

The EPS figure is disappointing when you consider that the number was $1.26 a share in the first quarter of this year. Net income figure of $6 million (after accounting for losses of $89 million from the international streaming revenue) is also disappointing when you consider that the figure in the same quarter of the previous year was $68 million. The only bit of comfort is that the result is better than the $5 million loss in the first quarter. The declining profitability underlines the rising cost of content and the company has reiterated that it will continue to target a total of 7 million domestic streaming subscribers for the current year which means that they need to add between 1.2 million and 1.8 million new customers. This is quite an ask when you consider that they were only able to add 0.53 million customers in the second quarter.

Around 10 months ago, Netflix launched services in Latin America and has surpassed one million members while six months after its launch in the UK and Ireland, it has reached one million members as well. The company points out that it is ahead of its European competitor LOVEFiLM in respect of every single important streaming metric. The international growth is important to Netflix and critical to its long-term success. The company says that the international segment currently accounts for 13% of its total streaming members and 50% of its additions for this quarter. In terms of competition, there is BskyB (which has better content), Sky’s Now TV ($23/month) and Amazon’s (AMZN) LoveFilm in the U.K., and from HuluPlus (priced the same as Netflix), HBOGO (a bundled offer with 29 million subscribers) and Amazon Prime (priced at $79/year) in the domestic market. Netflix says that it does not see any real threat yet from Amazon Prime and HuluPlus but it could face more serious competition from the new Redbox and Verizon’s (VZ) streaming video content service because of the reach of Verizon’s network. However the new service will take time to establish itself. HBOGO requires a cable subscription; many cost-conscious customers will be reluctant to pay the price. An interesting possibility may be a partnership between Netflix and HBO which could be a win-win for both companies as well as the consumer.

The rising cost of content continues to be a major concern because the current margins are slim and the company has learnt through harsh experience in 2011 that there is a very limited scope to increase pricing. In order to cope with the rising costs of licensing and content, the company needs to add new subscribers quickly in order to stay profitable. There are payments of $1.2 billion to be paid content providers such as Disney (DIS), CBS (CBS) and Time Warner’s (TWX) Warner Bros. There is considerable skepticism about the 2012 target of 7 million customers and one estimate shows that net domestic editions will only be around 6.77 million without taking into account the effect of larger customer churn and the impact of competition. Despite all the talk of international expansion, the company has yet to walk its talk and the international business has yet to have a profitable quarter.

Whenever I look at a potential investment, one of the key factors that influence my decision is the quality of management. And I am afraid that the Netflix management does not inspire any confidence in me. Despite all the hype, the streaming business is not doing well and the decision to jettison its DVD business now (which is profitable though declining) is questionable. All the eggs are now in the one basket of streaming operations and the prospects of a profitable global streaming business are still to be established. Even if the business attracts a large number of new subscribers, continuing demands from content providers will continue to squeeze margins and its price increases are ruled out, I wonder how the company is going to cope.

All in all, there are too many uncertainties for me to recommend Netflix as a possible buy. If you have an existing position, you can hold, but watch developments in the company closely and sell your holding at the first sign of any negative developments.