Netflix’s Woes Go Deeper Than Headlines


As Coinstar prepares to blow the doors off of the most recent quarter and the rest of the year, investors’ intuition might lead you to think Netflix’s April 23 earnings report will stink more than the last several.

Even though I have covered Netflix for some time now, I have no idea what they’ll report. I expect a loss, more bad news, and the obligatory dose of smoke and mirrors, but, at the end of the day, it’s difficult to predict what CEO Reed Hastings and CFO David Wells have in store on their dog-and-pony show of a conference call. And, more importantly, what they report really does not matter unless, of course, it includes meaningful and logical wholesale change to the business model.

Any impact from Coinstar’s success — meaningless. Last year’s Qwikster debacle — meaningless. Last year’s price increase — meaningless. This year’s under-the-radar split of DVD and streaming — same thing. Nothing Netflix has done over the last year — immediately dubbed as embarrassing blunders by wide swaths of the media — surprised me.

For example, I had a feeling the DVD/streaming split was coming again before Netflix announced it, quietly, on its blog in February. Earlier in the year, an anonymous emailer sent me a copy of a memo that I believe, based on conversations with a Netflix spokesman, is authentic. The memo was sent to staff by Netflix’s vice president of IT operations. It discussed a bunch of technical things involving DVD fulfillment and streaming, before referencing “Split 2.0.”

I immediately figured that Split 2.0 was just a not-so-fancy name for Qwikster 2.0. The Netflix spokesman, Steve Swasey, told me that the contents of the memo were insignificant to customers and only mattered to internal IT staff.

Technically, that’s true, however, if Split 2.0 relates to the February blog post announcing what amounts to another split, the memo, at the very least, indirectly mattered to customers. But, again, as I said at the outset, in the grand scheme of things, Split 2.0 or or the purchase of the domain — none of it means a darn thing. All of these Reed Hastings’ “blunders” “Saturday Night Live” had a ball poking fun at mean nothing. Each error was little more than another symptom that emerges as the result of a core disease eating away at a dying patient.

The well-respected author William D. Cohan quoted me and nicely summarized my outlook on Netflix in a recent Vanity Fair article:

[Pendola] wrote that he could not understand why, despite the separation fiasco and the near collapse of the stock, any number of publications and research analysts were still trumpeting Netflix as an investment. “Simply put, these moves that Reed Hastings made represent nothing more than desperate reactions to a broken business model,” he wrote.

He then wondered why, if Netflix’s business fundamentals were so good, it had suddenly decided to raise $400 million in new equity — what another blogger called “a desperate cash grab” with absolutely horrible terms. Pendola called “comical” the explanation from Steve Swasey, Netflix’s vice president of corporate communications, that, while the company had no “pressing need” for the cash, “it’s always nice to have more money than you need.” Concluded Pendola, “If you cannot clearly read the writing on the wall after everything that’s happened, you deserve to lose your money and average this dog down as it craters to below book value.”

The craziest thing about Netflix, through all of the craziness, is that the writing has been on the wall for well over a year. Oddly, every Keystone Cops-like episode produced and directed by Hastings was launched off of the core problem: Netflix is killing itself by executing an absolutely unworkable business model.

It became clear early in 2011 that Hastings had married himself to streaming. Initially, his “virtuous cycle” of subscriber growth and a profitable, high-margin DVD business funded his streaming ambitions. Even under that scenario, there was no way Netflix was going to be able to keep pace with digital content costs for long. Then, Hastings blew up DVD. In fact, just four-and-a-half months after “setting up a dedicated DVD division,” appointing a “12-year Netflix veteran” to run it and telling shareholders Netflix would “return to marketing our DVD by mail service” in the fourth quarter in an effort to “keep DVD as healthy as possible for as many years as possible,” Hastings said the following at an analyst conference last December: “DVD will do whatever it’s gonna do. We’re gonna try to, ah, not hurt it, but we’re not putting a lot of time and energy into doing anything particular around it.”

Of course, in between these two events, Netflix took to the Street to raise $400 million that the company apparently decided it wanted to keep in a rainy day fund.

So, yeah, there’s no need to concern yourself over what the Coinstar news means to Netflix. No matter what happens in the near-term, do not take your eye off of the ball. The endemic structural problems at Netflix have and will continue to only get worse, regardless of what happens on the company’s April 23 first-quarter 2012 conference call.

Because of the ever-present possibility of a “surprise” later this month, mixed with more smoke-and-mirrors, Netflix has long-dated, in-the-money LEAPS puts written all over it. Don’t fall for the allure of low premiums on near-dated, out-of-the-money calls . That’s a fools game. When you go far out into the future and deep in-the-money with options, you put time and intrinsic value on your side. While the ride can get rough, if Netflix implodes over the next 12 to 16 months, those puts can pay off.

Additional News: Citi Analyst Mark Mahaney’s Three Fixes for Netflix

Additional Views: Is Comcast’s Video Service Bad for Netflix?


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