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Analysts: Costs, Expansion Undermining Netflix

17 Oct, 2012 By: Erik Gruenwedel

Netflix reports third-quarter results Oct. 23

Costs associated with launching subscription video-on-demand service in Scandinavia and other countries, coupled with lower domestic subscriber growth, continue to hamper Netflix’s bottom line, analysts say.

Los Gatos, Calif.-based Netflix, which is paying billions to secure third-party content, is spending millions establishing SVOD beachheads abroad in an effort to corner a subscription streaming business attracting increased numbers of competitors. To pay for this expansion, Netflix is relying on continued domestic streaming subscriber growth, in addition to enduring high-margin disc membership.

Both of those metrics, however, continue to be squeezed as domestic sub growth wanes and Netflix management paradoxically gives rental discs the cold shoulder.

Eric Wold, analyst with B. Riley & Co. in Los Angeles, says Netflix spent heavily on content for its launch in Sweden and other countries and reportedly plans to launch service in France sometime next year.

Indeed, ITV Oct. 17 announced it signed a license deal with Netflix for select independent titles, including psychological drama, “Appropriate Adult,” starring Emily Watson and Dominic West. Other TV shows include “Lewis,” “Vera,” Agatha Christie’s “Poirot” and “Above Suspicion,” among others.

The programs will be available to Netflix streaming subscribers in Sweden, United Kingdom, Ireland and Scandinavia.

“We remain concerned that Netflix is expanding too quickly internationally with incremental content commitments and mixed results at a time when domestic competition is increasing,” Wold wrote in an Oct. 17 note. “Furthermore, with speculation that Netflix could enter France in early 2013, this would represent the fourth regional launch in 18 months (along with Latin America, UK/Ireland and Scandinavia).”

The analyst believes increasing competition from Hulu Plus (with more than 2 million subs), Amazon Prime Instant Video and Comcast’s Streampix poses a risk to both Netflix’s domestic and international subscriber growth and profitability.

“Our conviction levels (and potential valuation outlook) will remain low until the risk of profitability headwinds pass (competitive/content pressures or management’s desire to continuously reinvest),” Wold wrote.

Indeed, Netflix, which reports third-quarter results Oct. 23, is expected to downsize initial year-end domestic subscriber additions of 7 million, in addition to posting a loss of about 650,000 disc subs.

Michael Pachter, analyst with Wedbush Securities in Los Angeles, said Netflix will fall below projections of 1.76 million net new subs in the third quarter due in large part to the Summer Olympics. Pachter believes Netflix management will scale down year-end sub growth to about 5 million to 6 million predicated in part on the launch of Nintendo’s Wii U.

“However, we think the bulk of Wii U buyers already have Netflix accounts,” the analyst wrote in an Oct. 17 note.

In addition, Pachter said management has understated the costs associated with growing and sustaining domestic streaming, including costs associated with technology and development and general and administrative.

“We believe that a proper allocation of these line items would result in a domestic streaming segment that is much closer to operating at break-even or at a loss, hurting valuation,” he wrote.

Finally, both analysts remain perplexed at Netflix’s continued indifference toward disc subscribers considering the demo generates the highest margins (46%) and operating profit ($134 million) within the company. Indeed, signing up for by-mail rental discs requires going to a completely different website at www.dvd.netflix.com.

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