Reading Between The Lines Of Netflix' Ugly Earnings Report - An AOL Type Accounting Gimmick In The Making?
Yesterday Netflix reported a quarter which missed EPS, and provided a guidance that was essentially below the street. Yet for some reason the stock shot up 10% on what was perceived to be a dramatic pick up in subscribers and a very low Subscriber Acquisition Cost. We wonder if all those computers who bid up the stock with impunity, lifting all offers on the way up, were aware that in fact the subscriber metrics were a major disappointment. To wit from Bank of America: "without a dramatic lift in free subs as percent of total (from 2.8% in 2Q and 2.5% in 3Q09 to 6.3% in 4Q), Netflix would not have met Street expectations, and paying subscribers of 15.9mn (still up an impressive 46% y/y) missed our estimate by 275K." Yes, ladies and gents, it is the AOL scam all over again. Free subs are subs, the CEO will tell you, and it is all a matter of converting them. Ah yes. That worked out very well for the clusterfuck that is the dial up company. In other words, NFLX results were in reality a disaster across every vertical, and once Q4 is in the books and the inability to fool the vacuum tubes that free subs will become paying subs is realized, this overbloated bubble is in for a dramatic reacquaintance with gravity.
More from BofA:
This increase in free subscribers, due to an extension of the normal 2-week free trial period to a full month in most cases, also benefited subscriber acquisition cost (SAC) and churn. The company’s reported SAC of $19.81 was very impressive at down 26% y/y and 19% q/q, but it benefited from the inclusion of nearly 1.1mn free subscribers, or 26% of gross additions in the quarter. The company records the cost of free subscribers in its marketing line, but only the cost of servicing the subscription (approximately $4). Backing out the 605K more free subs than expected, SAC would have been around $22, still down 18% y/y but only in-line with consensus.
Without extension of free trial, NFLX would have missed churn
Churn benefits from the surge of free subs by adding a large number of subscribers to the denominator without adding new cancellations to the numerator of the churn equation. Backing out the 605K incremental free subscribers from the gross additions in the quarter would have made churn 3.91%, still down 45bps y/y but roughly flat q/q, and slightly worse than Street expectations of 3.8%.
Bulk of 4Q subscriber guidance increase likely due to free subs
Finally, management commentary that they plan to continue using this extended 1-month free trial program in 4Q and likely beyond is the bulk of the increase in subscribers in guidance. We are taking our 4Q ending subscriber estimate up from 18.4mn to 19.5mn, both near the top end of guidance which increased from 17.7-18.5mn to 19.0-19.7mn. Nearly 85% of our 1.2mn increase in 4Q subscriber estimates, however, comes from a 994K increase in free subscribers. Given that 4Q tends to be back-end loaded, more than a third of gross additions for the quarter could be free subs, suggesting that even our 1.6mn free subs (8% of total, up from 3.1% in our previous estimate and 3.1% in 4Q09) may still be low. It is conceivable that paying subscribers in 4Q could actually be lower than Street expectation prior to this increase in guidance.
And remember HFT robots: free means unpaid. There is a reason why this nearly $9 billion market cap company had just $7 million in free cash flow in the quarter (which in turn was a plunge from Q2 2010 and Q3 2009). Also, how this company can command a 25x multiple for BofA's $130 price target (based on 2012 earnings, also known as NM based on 2010) is beyond us... and also far below the closing price.