Netflix is 'broken' with no fix in sight, analyst says

Wedbush analyst Michael Pachter says that increased content costs, a precipitous decline in subscribers, and a "growth at all cost" mentality will continue to hurt Netflix in the future.

When will the bleeding stop at Netflix?
When will the bleeding stop at Netflix? Netflix

Netflix has endured an exceedingly difficult year. But things will only get worse in the coming months, says Wedbush analyst Michael Pachter.

Writing to investors in a research note today, Pachter said that Netflix "is broken," and its decision earlier this year to raise prices on customers who want to both rent DVDs and stream video content proved to be the catalyst that brought those flaws to light.

"It is clear that a price increase was necessary, and equally clear in hindsight that a 60 percent increase on the hybrid customer was too much," Pachter wrote to investors. "While we think that the company would have seen some customer defections and trade-downs at any price point, it is clear to us that the defections and trade-downs would have been less dramatic had the price increases been smaller."

But the damage is already done. According to Pachter, by year's end, Netflix will show a loss of 11 million "hybrid" customers that previously rented DVDs and streamed video content. He said he believes that 7 million of those customers will have traded down to the streaming-only option, while another 4 million will have "quit the Netflix service altogether."

Furthermore, Pachter said that Netflix will need to attract 15 million streaming-only subscribers to make up for that revenue shortfall--an impossible goal in the near-term, even though Netflix continues to expand internationally.

Netflix's international expansion started last year when it offered its streaming service to Canadian customers. Latin America consumers got a taste of Netflix earlier this year. In early 2012, Netflix will offer its streaming service to customers in the U.K. and Ireland.

Although Netflix has said that its international expansion is central to its growth, Pachter said he believes the company is following a strategy of "growth at all costs" without considering the impact its global expansion could have on profitability.

"At a minimum, we expect Netflix to lose $100 million internationally next year, and we think that the figure could rise to as much as $250 [million] to $300 million, based upon its Q4 guidance," Pachter said.

Those losses will grow out of rising content costs. Pachter argued that Netflix will pay an additional $200 million to $400 million for international rights to streaming content next year, which should push its worldwide content-streaming costs to between $1.3 billion and $2 billion. Netflix paid $800 million for streaming content this year.

Last month, Netflix reported that it lost 810,000 subscribers in the third quarter and said that it expects to post a global net loss next year. Those losses and a rise in content costs have affected Netflix's cash coffers so dramatically that the company was forced to raise $400 million earlier this month by way of a stock sale and private placement of convertible notes.

But $400 million might not get the job done. In a note to investors last week, Pachter said that Netflix ended the third quarter with $366 million in cash and short-term investments. The company's short- and long-term liabilities, however, "totaled roughly twelve times cash and short-term investments at the end of the third quarter."

All that could develop into a nightmare scenario for Netflix in 2012, Pachter said. He estimated that Netflix's losses could hit 35 cents per share--about $18 million--next year, but pointed out that the "estimate may prove to be exceedingly conservative" and rise to as much as $100 million.

Although Netflix isn't so willing to sound the alarms just yet, rebuffing calls to provide 2012 performance estimates, the company did acknowledge in a Securities and Exchange Commission filing earlier this month that if it can't turn things around, times will be tough.

"If we are unable to repair the damage to our brand and reverse negative subscriber growth, our business, results of operations, including cash flows, and financial condition will continue to be adversely affected," Netflix said.

Shareholders seem to have little faith in Netflix's ability to repair itself. Over the past six months, the company's stock is down 75 percent. As of this writing, Netflix is trading at $65.86, and Pachter believes it could hit $45 per share within the next year .

Netflix did not immediately respond to CNET's request for comment on Pachter's research.

 

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