Time to Cancel Netflix

 | Jul 23, 2013 | 10:00 AM EDT  | Comments
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I have a love/hate affair with Netflix (NFLX). I love the company's growth and crazy stock price appreciation, but I hate its business model. Netflix carries huge off balance sheet liabilities that seem impossible to pay down, while the company produces virtually no cash flow. Meanwhile, investors look the other way and the stock goes up almost every day.

One day, Netflix will either turn into a real operating company or it will crash and burn when investors realize it has a hollow business model. Netflix is trying to fake it until they make it.

Monday night, Netflix reported second-quarter earnings of $0.49 per share, $0.10 better than the consensus estimate. Revenue rose 20.2% to $1.07 billion, which was in line with analyst estimates.

The stock sold off sharply when the company said it added just 630,000 new U.S. video streaming subscribers. The company ended the quarter with 37.8 million customers. Investors were disappointed the company wasn't able to add more subscribers, given the company has been spending heavily on original programming. Investors hoped programs such as "House of Cards" and "Arrested Development" would drive new subscriptions. Many investors had expected closer to 680,000 net additions instead of the more modest 630,000. The company spent $593 million to acquire new content this quarter and investors have to ask themselves if that level of spending is sustainable.

For the third quarter, management said it expects third-quarter earnings per share(EPS) of $0.30-$0.56. The company also forecast total subscribers between 38.5 million and 40.3 million, which means the company expects between 700,000 and 2.5 million net new subscribers. Investors were disappointed in the third-quarter forecasts, since most analysts had modeled at least 880,000 net additions.

For the year, analysts expect $4.33 billion in revenue and earnings per share of $1.42, which implies a big growth pick up in the fourth quarter. Revenue has to grow at least 4% sequentially from the third quarter to the fourth quarter, but judging from the third-quarter forecast, business has to be very strong during the fourth quarter. The third-quarter is the key. If the third-quarter net additions come in soft, as they did in the second quarter, the stock is toast because there is no way the company will make the fourth quarter estimates.

The only thing holding up the stock is new net additions. As subscriber acquisition slows, investors will begin to worry about profitability and I don't want to be around for that. I worry that failure to exceed Street estimates of 880,000 net additions for the third quarter will chop the stock in half. For now, I would avoid Netflix.

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