Netflix is the Studios' Pawn, Not The Opposing Queen

I know it’s risky to take the other side of an issue from Defender of Liberty Ben Shapiro lest I end up like Piers Morgan. However, on the issue of Netflix, I am fairly confident in my contrarian analysis as I have a good deal of experience on the financial side of things.

I think Ben is overstating Netflix’s success regarding its quarterly earnings and the threat to Hollywood as Netflix rolls out original programming. Netflix is really nothing more than a long con at this point. The business model is not sustainable, and it presents no viable threat the studios. To the contrary, it exists at the pleasure of the studios. Netflix relies on their content and can never replace it.

There are two aspects regarding Netflix to be aware of. The first is that Netflix has billions of dollars in content obligations over the next few years. The second is that its present business model will not sustain it long enough to meet those obligations or even continue as a going concern. 

As Ben correctly surmises, soon everything will be streaming. DVDs are all but dead. Netflix’s DVD subscriptions dropped from 11.16 million to 8.22 million year over year, and by the way, that’s also down from 13.93 million in Q3 of 2011. Think about that – 40 percent of DVD subscribers are gone. Revenue fell from $370 million to $254 million (data comes from Netflix’s own shareholder letter and quarterly earnings statement).

Streaming subscriptions grew from 21.67 million to 27.14 million. That’s good news on the surface, except that unlimited streaming at $8 per month will not support the company. Revenue increased $113 million, but costs increased $75 million, and they backed off on marketing by $30 million. International streaming revenue increased $73 million but expenses increased by $100 million. International is operating at a loss.

This is not a winning model. As DVDs disappear, the streaming business is not generating enough revenue. Operational cash flow was $22 million, but that includes adding back a massive $1.6 billion because the company is amortizing its streaming content library, and I’m not certain that’s the best method of accounting for this.

Netflix burned through $80 million of cash. They have several billion dollars in off-balance sheet content obligations for content – which they do not disclose in their shareholder letter – that they simply will not be able to pay for. Netflix must compete with Amazon and Apple, both of which have tens of billions of cash with which they can outbid Netflix for premium content. In addition, Netflix now must contend with the Redbox-Verizon partnership to stream content. That’s another competitor, and again, Verizon has billions of cash on their balance sheet. Netflix has about $250 million.

At this point, Netflix is being used as the studios’ pawn, upon which it can fob off programming they have already profited from having sold into syndication. As for original programming, this is a loss leader, and it will fail in spectacular fashion (although Netflix CEO Reed Hastings will never admit it).

Netflix has spent over $100 million on House of Cards – a political thriller with Kevin Spacey and Robin Wright, executive produced by David Fincher. I have no doubt this will be a terrific show. But it won’t make a lick of difference to Netflix financially.

Here’s a hard truth DirecTV learned when it picked up Damages from FX. DirecTV hoped that if even a fraction of the audience from Damages who weren’t subscribers, became subscribers in order to see the program exclusively on DirecTV, they would see a great return on investment. The problem is that this audience transfer never materialized and if it did, there is simply no way to determine how many actually joined. Thus, Damages was considered “a retention play.” That’s the same language Netflix is using for House of Cards and, wouldn’t you know it, Netflix stopped issuing churn rate a while ago. When a company stops providing transparency, there’s a reason – one that the company doesn’t want the investing public to know.

Because House of Cards will offer all the episodes at once, any new subscribers it picks up strictly to see the show could join for one free month, then cancel. Some will likely stick around, but we don’t know for how long because Netflix doesn’t issue churn numbers any more. This will prove to be an almost complete write-off for Netflix’s $100+ investment, but Netflix management will never admit to it.

There is a model for original programming for Netflix that can work, but this isn’t it. What would work? That’s my own proprietary project. Sorry, Netflix.

Now, Ben is correct that crappy content produced by the studios is what is threatening its survival. Actual number of tickets sold to consumers has fallen by more than 20 percent over the past decade. However, Netflix is the pawn of the studios, not the opposing Queen. And sooner rather than later, that pawn will be taken from the board.