Wednesday, July 20, 2016

We Would Buy NFLX At Much Lower Levels in Anticipation of a Takeover.

It is still seems possible that Netflix (NFLX) has considerable downside left in the shares. We think the company is burning through its cash position rapidly and will need to raise capital or find a strategic partner in the next two years.

We had been owners of the shares particularly after Netflix made a deal with Disney for rights to stream all of its films-- including the product of Lucasfilm Studios.  With NFLX down almost 30% in a year we would normally be buyers of such an appealing, fast growing consumer business.

But, we don't see NFLX as a standalone business. We see it as potentially an effective distribution arm for a major content company--Disney being the primary candidate to buy Netflix. And, so we are waiting to buy NFLX at much lower levels in anticipation of a takeout. We also have no good way to value the company. We couldn't realistically estimate net free cash flow numbers for NFLX on a standalone basis. And any estimate based on membership count would be beyond speculative.

In NFLX 10-Q of July 18th, the dilemma which the company faces is starkly apparent.  The company is burning through cash -- $454 million in the first six months of 2016, up from $301 million in the prior year six months-an amount equal to 25% of its existing cash position. At the same time, domestic memberships stalled with net additions falling to 162K from 901K an 82% decline. Domestic revenues rose 18% to $1.209 billion, with costs up almost as much 15% to $754 million. Even international net additions to the streaming service stalled with growth falling by 36% to 1.5 million additions. Rates were raised pretty much across the board--with the end of grandfathered pricing of $7.99 to almost 50% of its members. The price increases helped to boost revenue, but increases in program spending --both on an accounting basis and a cash basis rose faster. The consequences are laid out succinctly in language under liquidity and capital resources.

"Although we currently anticipate that cash flows from operations, together with our available funds, will continue to be sufficient to meet our cash needs for at least the next twelve months, to fund our continued content investments, we are likely to raise additional capital in future periods."

We worry that the current roll-off of grandfathered memberships and resulting price increases will result in additional cancellations of memberships. We anticipate continued increases in program expenses and obligations though we these may moderate as the company seems to understand the critical liquidity juncture which fast approaches.

Currently, we anticipate cash burn will rise to over $500 million for the next six months and move potential higher in the six months following. Without much hope of generating free cash flow, Netflix will need financing in 2017.  Will the market be receptive to additional equity financing? We don't know. Equity financing may temporarily allow the company to expand its subscriptions and to create and or acquire new rights, but not forever.

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