Will Today's Embarrassing Outage Force Netflix To Do A Follow-On Stock Offering?

Tyler Durden's picture

The biggest story today for video rental/video streaming company Netflix was not its parabolic move higher on earnings that left many scratching their heads, but that the company's exposure of just how vulnerable, and potentially unprepared, to growing pains it is, after its website suffered a multi-hour outage preventing clients (both paying and free) from accessing any streaming movies. And the company, which is betting if not the ranch, the definitely its cash flow on the transition to streaming (in Q3 it spent $115 million on video streaming rights, an 11-fold increase from the same time last year) may very well be unprepared for the priced in exponential growth in new users (even more so since as we pointed out earlier, the bulk of the expansion is to non-paying customers). The reason, as AP pointed out earlier, is that Netflix's streaming service has become so popular that it is now the
largest source of U.S. Internet traffic during peak evening hours
. Streaming
by Netflix subscribers accounted for about one-fifth of that peak-time
, more than double the volume flowing from Google Inc.'s YouTube. And this massive infrastructure is supported by... $120 million in PP&E!? Indicatively Google is almost $5 billion. And since the market is expecting continued parabolic growth to its existing customer base of 15.9 million paid users to validate the new business model to which it attributes a lofty 30x+ PE of 2012 Earnings (a deja vu of the dot com days of "story stocks"), the company will soon have no choice but to actually expand its seemingly underfunded infrastructure, which it currently carries at $125 million on its books. Unless, of course, it wants to lose exasperated clients with an ultra short attention span who demand instant gratification and who can easily find substitute streaming providers in these days of Hulu (which itself is about to IPO), and numerous cable channel hosted alternatives. The big problem is that with $8 million of non GAAP free cash flow as disclosed in its Q3 earning release, there is no way this expansion can be funded organically.  Furthermore, as the company is currently below its self-disclosed cash floor level, is the only option for Netflix to come out with a follow on offering, and fast? What that would do to a stock that has under $200 million in book equity and almost $9 billion in market cap we leave to our readers' imagination.

Why would NetFlix need to do an offering? As management disclosed on page 6 of its MD&A, "In terms of future buybacks, we have no plans to dip below $260 million in cash and cash equivalents." Funny, because the company had $257 million in cash as of the end of Q3. Additionally, up until recently Netflix was aggressively trying to telegraph to the public that its stock was undervalued having issued $200 million in debt to, among other things, buy back stock. To quote management: "During the quarter, we continued to use excess cash for share repurchases. In total we spent $58.6 million to purchase 530 thousand shares at an average cost of $110." The bolded statement may also be a further indication of future intent: the CFO would be rather naive to not take advantage of a 50% move higher literally in days, on his investment in his own shares.

What about further debt issuance? The recently (November 2009) issued $200 million in unsecured debt (at 8.5%!) has a carve out for a $300 million credit facility, but the company was already in a rush to repay its previous $100 million credit facility (the purpose of the note issuance) so presumably the banks were giving the company a bit of a hard time about collateral that could be bought in any subway in New York at one tenth the price. And with pledgeable assets essentially consisting of $260 million in DVD library content, good luck getting anything close to a 50% LTV on that, especially from a bank which may have "some" MBS exposure.

How about more unsecured debt? The Limitation on Incurrence of Indebtedness has a 3.5x consolidated leverage top. While the denominator is based on EBITDA, we have a feeling that with $110 million in LTM non-GAAP FCF, any new unsecured bondholders will make the max allowable debt ceiling based off of that number, and thus cap new debt at around $100 million. And any new debt issuance at or around 8%, which is not expressly designed for shareholder friendly purposes, will certainly be frowned upon by shareholders.

Netflix spends roughly $40 million on PPE per year and has already hit bandwidth capacity. We estimate the Company would need to roughly double this number to have at least some capacity for the future without running into capacity bottlenecks again. And while this number in itself is not large on the surface, the far bigger nut that NFLX has to crack in conjunction is the suddenly exploding cost associated with its transition to a streaming content provider: a transition which as we pointed out earlier cost $115.1 million in Q3 alone compared to just $66.2 million in Q2 (even as absolute gross profit remained flat sequentially) and $10 million in Q3 2009: what some would call a linear progression. Maintaining this level of streaming content expenditures makes it inevitable that the company will have to resort to some form of financing, especially since its DVD library content acquisition costs have already dropped to a $30 million maintenance level as NFLX seeks to move away from its old business "mail order" model.

In other words, with the company likely needing to finance between $100 and $200 million in funding needs (over what it can fund using debt) just to keep its new business line growing (assuming revenue does keep growing instead of merely adding free subscribers and churn), we are somewhat confident that NFLX will be forced to announce a stock offering in the interim, especially with its stock at such lofty valuations. And after all, with everyone a speculator, who can fault the company at taking a piece of the pie: the CFO has already made a 50% profit on his stock buybacks over the past quarter. In fact, we are confident that the bond offering underwriters of JP Morgan and Morgan Stanley are already hard at work pitching a modest follow on offering to the management team. After all, now that the hedge fund model of banking is no more, investment bankers are once again reminded what it means to pitch deals.

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doolittlegeorge's picture

i say "do it and find out."  was it "the globe.com" that was once worth more than Sears? and that was all it was!  "the globe.com."  hahahahahaha.  didn't that guy do a secondary?  something about "i wish i hadn't" or something like that.  at the rate our country is going "we all could be a billionaire, too...but just for a nanosecond."  and we'll have "trillionaires" who "play basketball."  and lemon drop stars with lollipop ships. and...and...what's the yen up to this AM anyways?

count_zero's picture

I love netflix, but 70 p/e is insane, with all the other #s. Everyone apparently thinks they're the next apple/ms.

I sold down to my original investment (play money) recently, even tho it was a short term tax gain. And I _HATE_ short term gains.

palmereldritch's picture

Thread soundtrack


Apparently the problem may have been anime ninjas


Nihilarian's picture

Netflix... sounds awefully familiar to Netzero. Deja Vu, bitches.

Excellent analysis btw.

As a former Netflix subscriber (I cancelled last month), I'm curious to know what accounting treatment they implement on subscribers that "suspend their account/put their account on hold". I did that for almost a year (I think they allow for a max duration of several months before they automatically reactivate your account). But still, that MUST affect their cash flows, and since these users "put their account on hold" and "didn't cancel their account"... could be inflating their subscription numbers substantially. I was a 'paying' subscriber for a year, yet I paid for maybe 3 months at the most.

Nihilarian's picture

Is bandwidth a rare earth mineral? Goddamn Chinese!

williambanzai7's picture

I have a feeling that the only one with the pipes necessary for this is the OOgly GooGLY MOnSTer!

PuppetRepubl1c's picture

well if the market corrects downward it may be a good time for Google to buy them up, hell im suprised google hasn't bought them already!  (market cap is way to high to buy them now, they are definitely over valued)


If Google were to buy Netflix it would make apple crap themselves but for the consumers of Netflix's services it would probably work out great

dark pools of soros's picture

better Google than Apple buy Netflix or the only way to use it would be with Apple TV and iPhads

Vampyroteuthis infernalis's picture

Google is not going to buy at this ridiculous price!

waylon153's picture

This is one on the best purchases I've ever made.  My family uses it every day and at $18 a month we get our money's worth.  We could pay double that and not even blink an eye.  We've been subscribers for over two years and find that it's a cheap form of entertainment as we are paying off all other kinds of debt.  We used to average 30 mail movies a month but since the online library has grown (as our taste) we've probably only ordered 3 movies by mail last month.

1.  It would be strange to do an IPO so soon after a buyback but I think the surge in new subscribers probably has altered the original growth model/plan.

2.  Netflix could easily raise prices.  Our family really only watches about 8 shows regularly on cable television in addition to sports (football) on Sunday.  We pay over $60/month for that service. 

3.  I doubt Netflix will continue to spending $115MM on streaming rights.  It would probably cut that number way back and negotiate lower rates with new and existing distributors.  We've also seen a huge increase in foreign films (which I'm guessing are much cheaper).

4.  Bandwidth is the issue.  What constitutes peak hours?  1-2 hours per day?  Why invest heavily in infrastructure that opens off-hours even wider and only marginally boosts peak hours?  Can you target an infrastructure increase in peak hours only?

5.  Probably a bigger bond offering after raising prices.

6.  Remember, they've still got (hundreds of?) thousands of manufactured dvd's sitting on the shelves.  It's not like they are going to completely shut down the regional distribution centers.  It's still making money, only at lower margins.  

7.  I agree that the P/E is too high.  Look for a correction (along with the rest of the market). 

midtowng's picture

I love Netflicks too. I've been using it for at least five years. I've seen tons of movies for a Hell of a lot less than renting from Blockbuster.

 But their stock reminds me of a Dot-Com company like Amazon. They may having a working business model, but that doesn't mean they are a good investment.

PuppetRepubl1c's picture

yea if i still had a position in NFLX i would have sold after the massive upsing today.  I think they are a great company but way overvalued.  Of course they could get bought out by someone like Google and it could take off to the moon.

Arkadaba's picture

I love Netflix because they saw an opportunity at one point (a few years ago) and acted on it. Bad news is that they haven't continued to innovate - the future is not one that relies on the post office for delivery. Sorry.

Before signing off, wanted to share this piece of Canadian humor (or humour depending on where you are):


PuppetRepubl1c's picture

In netflix's defense i believe they have innovated in the only possible way they could, streaming directly to the living room of americans.  I think their decision to put their streaming service on every gaming console (and install it by default in all new samsung and sony tvs) was a genius idea.  Of course they are always going to have thin margins because the content providers demand their pound of flesh (and bandwidth costs are always going to be huge).


From the point of view as a consumer i absolutely love their service, i can watch thousands of great movies streaming onto my 58" plasma from the comfort of my couch (via PS3).  Plus the movie selection absolutely destroys anything cable has to offer (fantastic foreign & classic selection which i love).  The cable company i use still tries to charge me $5-8 for a single streaming rental (for the same movies redbox offers for $1 and i get from netflix!).  Please!!! the prices they try to charge are insane, it makes netflix look like the best deal around!





foofoojin's picture

Only cause it is not mentioned. Playstation 3 owners went "Diskless" this week on the service. before this week you had to get a special disk and insert it into your PS3 to access netflix steaming service.  Now it's just two presses of buttons on the controller. my little brother was getting disconects the first night of the new system. So as word has spread in the PS3 community all this week. the problems have gotten worse.  So yes there is an infastucture investment needed.

-Michelle-'s picture

Wii owners also went diskless this week.

Djirk's picture

There are ways to get krafty now days with infrastructure financing. I bet they could work out a leasing arrangement with one of the big hardware players. (Certainly not yields for cash out there) Then leverage some virtaulization software for max capacity utilization.

OK sites still do crash (ahem ZH) but it is not the wild west gold rush days of the 90's.

Speaking of virtualization, based on CRM and VMW valuations, NFLX could go much higher before it reaches nosebleed levels.

Growth baby!





Tyler Durden's picture

Zero Hedge has to invest substantial amounts in its infrastructure to prevent current and future crashes. Luckily our readers' donations help with that. We are not so sure a donation based model would be sufficient for NetFlix, although with millions of free subscribers each quarters they may need that soon.

pitz's picture

Virtualization can't possibly help Netflix; virtualization is for taking many un or under-utilized machines and combining them into one with a minimum in reconfiguration.  Hardly Netflix's problem.

MsCreant's picture

posted something very old by accident.

bada boom's picture

The higher amount of free subscriptions is no concern, in fact, it's a sign of good things to come.  For 8.99 a month, unlimited streaming, how can you beat this?   I believe the trial offer requires the credit card up front, so most will roll over to subscriptions.

Yes, building out their network will eat into profit.

The biggest concern to netflix should be,

Broadband consumption, how much more can the internet take and when do the service providers say enough is enough.  Especially the likes of Time Warner who may be losing cable customers to this.  ATT once offered unlimited bandwidth for their cell phones, but not now.  I could see most wired providers doing the same at some point.

Secondly, competition.  I don't see many barriers to amazon, or other companies deciding to do the same thing, unless the broadband issue takes hold.  Right now, amazon offers pay per view, but what would happen to netflix if they offer a flat fee unlimited streaming plan.


Buttcathead's picture

Dont worry about it, the gubmint will give them all the money they want.

quasimodo's picture

Streaming accounts for 1/5 of traffic? Holy batshit Batman.

Seems to me the sheeple are indeed still spending plenty of time with the screen. Poor Idol :)

lbrecken's picture

You forgot to mention that study which gave it 20% of traffic also stated that 1.8% of subs generate that.  So the logical question I ask is how Hastings can mislead investors into believing its a pure streaming company now?

Bob's picture

Holy shit!  Something tells me they could soon be the victims of their own success in a best case scenario of growing paid subscriptions.  To my eye, their online streaming service is reminiscent of the early cell phone market--at first, nobody dumped their landlines (hell, most early adopters who did probably shifted, like me, to VOIP.)  When people eventually began to see that they no longer had a need for superfluous phone expense in landlines, they dropped them and cell use exploded.  But pricing in that market remained on per-minute basis, however.  Plenty of funding for increased infrastructure demands. 

If we see a similar evolution in movie streaming, I would expect that those 1.8% of subscribers--who now represent 20% of total web traffic!--to be joined by other subscribers who will increase their bandwidth demands as they significantly cut their cable tv bills (going to basic packages, say, and definitely eliminating "on-demand" purchases.)  Unlike the situation in the cell phone industry, however, usage of streaming is priced flat rate. 

If the level of usage exhibited by that 1.8% of users were to rise to a mere 4.8%, then that would account for 60% of web traffic????

Something is gonna have to give.  I can't see this being sustainable.  No way. 

FischerBlack's picture

Ultimately, this business model is doomed to fail. We've seen this before. Netflix is free-riding on another provider's content delivery system. The math is very simple. Those providers will eventually shut Netflix out. It's inevitable.

Tyler Durden's picture

Reminds one of Lodgenet: closed streaming ecosystem, and no barriers to entry to boot. Was supposed to go to $100/share three years ago...

Mercury's picture

This is Broadcast.com all over again.

The problem with streaming content in general is that each new user puts the same big load on the system.  There's no scale.  With real broadcast TV and radio you hook the transmitter to an antenna and off you go.  If one person or a million people are tuning into your program, it's the same fixed cost and resource utilization.  With streaming online content it's an additional Xkbs/sec weighing down the infrastructure everytime someone else logs on.  What Mark Cuban's Broadcast.com did and Netflix is doing isn't broadcasting it's individual, point to point data transmission.

This was why Broadcast.com was never really viable - especially back then when all the pipes were smaller.  The problem is still the same today, it's just that all the numbers are bigger.

For this movie it's time to start casting for the role of Yahoo (Broadcast.com's purchaser).

Non Passaran's picture

It could be possible to locally cache top x% of most requested content or work with the likes of Akamai to achieve significant offload (at a price).

theopco's picture

Would I be willing to change ISPs to continue using netflix?

You betcha

Bob's picture

That solution will be headed off at the pass, imo.  Too much load=too big a problem for everyone.

Bob's picture

I see you got there ahead of me (my comment above.)  It's absolutely inevitable.  Even non-Netflick web users would support it. 

bada boom's picture

What that would do to a stock that has under $200 million in book equity and almost $9 billion in market cap we leave to our readers' imagination.

Let us not forget where we live, Imaginationland.


Without imagination, what would any stock be priced? 

What would a FRN be worth...


max2205's picture

APPLE buy out. They got $80 b

lbrecken's picture

By the positive posts here I see HASTINGS has actors posting here to?

lbrecken's picture

Do you even know this company only has a Q&A call no commentary and it only takes emal questions with no live callers?  Nothing adds up here and and this whole thing stinks.

PuppetRepubl1c's picture

my question is why do you need live support?  If you have a samsung tv, sony tv, or any one of the major gaming consols you just press a button and it works (i am extremely tech savvy but have not needed to change even one router setting to get netflix to work).  There is no need for live support.



PhotonJohn's picture

Great analysis! What I do not understand is where does the new instant download fit in? I like the idea that Amazon has of renting a movie through devices like my Bluray player, but I will be damned if I am going to spend $5. I can walk 2 blocks and get a Bluray for $1.50 at Redbox. How do they think they can compete? For $2 HD streamed I am all in and would prolly cancel my Netflix. Seems they have their pricing model all wrong.


I am suprised that NFLX has not jumped onto this bandwagon but your analysis and the debacle that just happened clearly shows they cannot handle it. If AMZN wises up and changes pricing, watch out below on NFLX.

lbrecken's picture

VUDU already has $2 HD Rentals.......they just lowered the price.....



-273's picture

Real hocus pocus, check what he thinks of netfilx at 2mins. Actually the dude is carrying a netflix mic the whole time for some reason. Dope documentary and dope tune:


trav7777's picture

NFLX currently has a nice niche but price compression is coming.

Playstation network, due to Sony ownership, has a gigantic catalog of movies to watch and access to the Sony title portfolio.  Problem is they want 3 fucking dollars to watch a movie ONE time.  On-Demand from Verizon or Comcast are similar in price.  They simply don't offer good value, which is why people put up with waiting a couple days for a DVD to show up in the mail.

What NFLX needs to do to grow subscribers is to cut deals with Bollywood.  I'm serious.  Go aggressively to the Indian, Brazilian, and Mexican movie industries and just take a global approach to it.  While this may not seem as glamorous as overpriced US film content, the bang for buck should be cheaper.

One of the problems with the model, and redbox is running into it too, is that Hollywood has a GROSSLY exaggerated idea as to the worth of the shit they produce these days.  The on-demand services seem to believe a movie is worth $3 or so, but Redbox is proving - or was prior to the studios locking out their price discovery - that really people are looking to pay $1.

I used to use Redbox all the time until the studios ganged up on them.  With bullies like Comcast having the deeper, stupider pockets, and their concept of their subscriber base as a captive audience, it's really a matter of time before they sign some IDIOTIC rights deal with the greedy semites guaranteeing that a movie view continues to cost $3 or $4, and locking Redbox and NFLX out of the channel (along with bandwidth capping), while attempting to pass that cost on via price increases for basic cable and internet. 

It won't work...PSN has been a total failure at $4/show; that is just too much, even for Sony's title catalog.

-Michelle-'s picture

Roku seems to be anticipating changes with Netflix.  They're pushing a new Hulu Plus channel pretty hard.

lbrecken's picture

Read on excellent analysis, but once again that traffic data he sites came from only 1.8% of users not the majority......



PuppetRepubl1c's picture

The HULU people are fucking morons, they actually think i am going to pay $10 a month just to watch tv episodes?  Please!  the Netflix catalogue of content has then beat by a mile and costs the same.  Also, in all honesty i can get every tv show for free off the Internet anyway, so the $10 a month they were trying to charge was absolutely laughable.



-Michelle-'s picture

Beyond that, the incentive is just not there to switch.  We get our internet through the cable company.  We have limited basic cable, the least expensive plan available.  The only reason we have it is because internet plus limited basic cable is 25 cents cheaper than internet alone.

I have to have internet to access Hulu Plus.  But my cable company has already made reasonably sure that I will keep cable on.  Why would I pay another $5 or $10 per month to have access to the same shows broadcast for "free" on basic cable?

Meanwhile, Amazon is absolutely insane with the prices they charge for "rentals."  $5.99 for 24 hour access to one movie?  I have a Redbox down the street if I get desperate for entertainment.

Now, if I could only muster enthusiasm for the pablum so lovingly bestowed upon us by Hollywood...

Trainwreck's picture

Netflix' need to spend on infrastructure is minimal. They have moved most of their operations onto Amazon Web Services and thus pay only monthly usage charges. No CAPEX. Bandwidth is also a monthly charge to Akamai/XYZ CDN provider so no bandwidth investment required there either. Netflix is rapidly eliminating it's need to invest in technology infrastructure so it can spend more on content rights. Eliminating the processing of physical disks will save $700 million in postage alone! Netflix may indeed do a follow on but it won't be to fund infrastructure.



lbrecken's picture

So you can half the trash of NFLX on PPV so you pay $10/mth there?  And TWRECK all monies saved on postage you assume will offset the soon to be downgraded prices in streaming.  So wake the hell up.