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Whitney Tilson’s Take on Netflix Successful Quarter – He Is Still Holding Despite Share Price Increase

January 26, 2012 | About:
CanadianValue

CanadianValue

212 followers
Netflix’s quarter (see attached earnings release/letter) was very strong across the board and blew away analysts’ estimates, and guidance was strong as well. Here are the highlights:

· Most importantly, net domestic streaming subscribers increased by 220,000, with particular acceleration in the last month of the quarter (Dec.), where Netflix “not only returned to strongly positive net streaming additions (aided by strong seasonal gross adds) but exceeded our forecast. In particular, we saw fewer streaming cancellations, as well as lower migration to DVD-only plans, resulting in the outperformance for streaming members.”

· Contribution margin in this segment was 10.9%, far above the company’s and analysts’ estimates of 8%, and guidance is to maintain 11% in Q1 12 and then increase by a full percentage point per quarter the rest of the year.

· International streaming subs grew by 380,000, so total streaming subs grew by over 600,000. This is still far below the peak net additions of 3.3 million in Q1 11, but it’s a complete turnaround from the loss of 810,000 the previous quarter, so there’s a very favorable trend – and guidance for Q1 12 is for 1.7 million net additions.

· EPS of 73c was far above consensus estimates of 55c.

· Revenue of $876M was well above estimates of $855M.

· Free cash flow was $34 million, up from $14 million the previous quarter.

· There are a lot of competitors out there, which Netflix discusses extensively on pages 3-4, but they don’t seem to be getting much traction or impacting Netflix to a material degree: “Both Amazon and Hulu Plus’s content is a fraction of our content, and we believe their respective total viewing hours are each less than 10% of ours.”

· The DVD-by-mail business, Netflix’s cash cow, lost 2.76 million (19.8%) of its customers in Q4, but that’s not surprising given the huge price increase from $2 to $8 per month (it used to be $9.99/mo. for both streaming and DVD-by-mail, and it’s now $7.99/mo. each). Netflix guided to 1.5 million cancellations in Q1 12 (13.4%), “with the sequential decline moderating in future quarters.” The business remains highly profitable (a 52.4% contribution margin in Q4, leading to $194M in contribution profit), and Netflix expects that it will remain so: “The DVD business model is predominantly variable cost based. So, as the size of the market opportunity continues to decline, we expect healthy contribution profit margins to be maintained.”

· Customers love the streaming service, as evidenced by the fact that “Members enjoyed over 2 billion hours of Netflix streaming video in Q4, which is approximately 30 hours per member per month on average.” Netflix is a tremendous value, offering a wide range of entertainment for only 27 cents per hour ($7.99/mo. divided by 30 hours/mo. of average viewing).

We know the bear thesis well – we wrote about it extensively a little over a year ago (http://valueinvestingletter.com/why-were-short-netflix.html) – and it just doesn’t hold much water anymore. The key pillars of the current bear thesis are that Netflix permanently damaged its brand last year with the price increase and Qwikster debacle, so subscribers would continue to flee, thereby reducing cash flow at a time when the cost of content commitments (which are fixed) are skyrocketing, triggering a cash crisis and a collapse of the stock. We couldn’t rule out this scenario, which is why we sized this position in the 5-6% range, but the odds of it just dropped a lot in light of yesterday’s earnings report. It shows convincingly that the furor over last year’s missteps is fading, subscribers are once again flocking to – and heavily using – the streaming service, the international opportunity is robust (who knew that Netflix is available in 47 countries?), and that the company is in good shape financially to weather this year’s small expected losses.

All of this didn’t change the mind of one analyst, Michael Pachter of Wedbush Securities, who appeared on CNBC’s Fast Money just after me and said, “The company was more out of touch than I thought they were before. They’re making light of their diminishing content quality.” We think he’s the one out of touch, as Netflix is hugely focused on streaming content quality and this topic is discussed at length on pages 2, 3, 7 and 8 in the attached earnings release. In addition, Netflix’s streaming content is increasing in quality, even with the loss of the Starz titles. In fact, Starz is the big loser here: they turned down what was surely a very generous offer and instead tried to extort Netflix, so Netflix walked – and then went around Starz and got back many (most?) of the lost titles by negotiating directly with the content owners.

This is a very important development that undermines of the key pillars of the bear thesis –namely, that Netflix’s streaming business will never be very profitable because content providers hold all of the cards. This would be true if Netflix had to offer all movies and TV shows, but it doesn’t. One of the key insights from our survey a year ago of 500+ Netflix customers is that they don’t expect a huge selection of the latest, most popular movies and TV shows for a mere $7.99/month. They only need to find something enjoyable to watch for one hour a day on average. This gives Netflix the power to play content providers off against one another. If Starz tries to extort Netflix, Netflix can walk and buy other equally good content from someone else. Netflix is providing a huge, brand new revenue stream to all sorts of content providers, which gives it a lot of negotiating power. And here’s the key: nobody else has even a tiny fraction of the number of subscribers that Netflix has (Hulu has a bit over 1 million, less than 5% of Netflix), so nobody else can bid anything close to what Netflix can. How much is Starz is going to get for its content that Netflix walked away from? Likely only a tiny fraction of what Netflix was offering. (It remains to be seen whether Apple, Amazon, HBO, Verizon, and the cable providers, who obviously do have tens of millions of subscribers, can become effective competitors – this is a risk we’re monitoring closely. But these are all much bigger companies, with 10x-100x Netflix’s market cap, so if they wanted to make a serious push in this area, it would be logical for one of them to buy Netflix, rather than spend billions trying to dislodge it.)

For an analogy of how important it is that Netflix doesn’t have to provide all content, consider Costco and Wal-Mart. How does Costco buy at lower prices than Wal-Mart (and pass greater savings along to its customers), despite being a fraction of the size? Costco and Wal-Mart stores are roughly the same size, yet Costco only carries approximately 5,000 SKUs, whereas Wal-Mart carries 100,000+. Take light bulbs, for example. I’m making this up, but let’s say that the average Wal-Mart carries Sylvania, Phillips and GE bulbs, 40, 60 and 100 watt, in packages of 4, 8 and 12. That’s 27 SKUs (3 x 3 x 3). Let’s say that Costco, on the other hand, sells a 12-pack of 60- and 100-watt bulbs made by one company – that’s 2 SKUs. So when the buyers for Costco and Wal-Mart go to the three manufacturers to negotiate the best price, the Costco buyer says, “We only want two SKUs and we’ll give you more volume in those SKUs than anyone else – and we’re only going to carry one of you, so whoever has the lowest price gets 100% of our business.” The Wal-Mart buyer can’t say that – all three know they’re going to share Wal-Mart’s business, plus each manufacturer has to incur the added cost of supplying nine SKUs – so guess who gets the lower price? Netflix has similar advantages of being able to play suppliers off against each other to get a good price.

Regarding position sizing, Whitney disclosed on CNBC last night (see article and video at:www.cnbc.com/id/46138387) that we trimmed our Netflix position going into the earnings report, yet said we’re as bullish as ever and think the stock is a good bet to double this year. The explanation for this apparent inconsistency is that we have to carefully manage Netflix’s position size for risk management purposes because of the wide range of potential outcomes, including some severe downside scenarios. When we purchased the stock last year, we decided that we were comfortable with a 5-6% position, which is where it was entering this year. As the stock quickly ran up 40% prior to the earnings report, it became larger than a 7% position at the same time that the margin of safety had shrunk (our estimate of intrinsic value didn't go up 40%), so logic dictated trimming a bit, which we did (back to the 5-6% range). Our selling didn't reflect any change in our bullishness on the company – rather just the sharp rise in the stock price with little change in the underlying fundamentals.

So with today’s run-up, will we be trimming it back to the 5-6% range? No. We’re now comfortable with a somewhat larger position because we have a lot of new information that changes the odds of the various possible outcomes: for the reasons discussed above, the likelihood of a severe downside scenario has declined significantly, while the upside scenarios are both more likely and more robust. In terms of safety, this is no Berkshire Hathaway to be sure, but it’s much safer today than it was yesterday.

NFLX Q4 11-rep 1-25-12

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CanadianValue
http://valueinvestorcanada.blogspot.com/

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