Analyst: Netflix Business Model Is (Still) Broken

The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities.

Movie Rental Industry

Key Redbox releases this year (with domestic box office total in millions from

o 6/25: The Call ($52)

o 7/2: Identity Thief ($135), A Good Day to Die Hard ($67).

Key Redbox releases last year (with domestic box office total in millions from

o 6/26: 21 Jump Street ($138), A Thousand Words ($18).

o 7/3: Safe House ($126), Wrath of the Titans ($84), Act of Valor ($70), Big Miracle ($20).

office compared to zero last year. DVD rentals for the upcoming two-week period should outperform the same period last year.

Redbox should benefit from a very strong summer release schedule. There are 22 films with budgets greater than $100 million scheduled this summer, compared to 15 last year and an average of 12 – 15 most years. Many moviegoers will want to see several films, but the crowding of the release schedule will make it impractical for them to see all of the movies they care about in theaters. As a result, we believe that people are far more likely to rent a greater number of these films when released on DVD. The average time from theatrical release to DVD is under five months, and even for movies falling within the 28-day window (around half of Outerwall’s supply), DVDs are generally available within six months of release. That means that the majority of big-budget films will be available in Q3 or Q4 for Outerwall, and Outerwall’s guidance implies that they understand this. As a reminder, the high end of Outerwall’s guidance calls for Redbox revenue growth from $1 billion in the first half to $1.2 billion in the second half.

Netflix (NASDAQ:NFLX) believes it can grow its domestic footprint to 60 – 90 million households; with only 90 million households connected to the Internet, this implies 66 – 100 percent penetration and discounts potential competition. Management expects revenues to grow faster than content and marketing spending, suggesting increasing profitability; we believe Netflix’s business model is broken. Only 85 million U.S. households pay for access to television currently, so it seems a stretch to presume that 70 percent (at the low end of Netflix’s goal) will add an additional pay layer from ANY provider, especially in light of increased competition from Redbox Instant by Verizon (NYSE:VZ), Amazon (NASDAQ:AMZN), Hulu, and, most recently, content providers establishing their own services.

Similarly, it seems illogical to presume that Netflix can grow its base by spending less on content per customer; the company appears convinced that it can add 100 – 200 percent to its domestic subscriber base, yet seems determined to grow content spending by less than this amount. In our view, the content owners are interested in maximizing profits for their stakeholders, and are unlikely to allow this to occur. Instead, we expect to see content quantity decline as Netflix endeavors to cut costs while buying higher quality content. Over the last two quarters, free cash flow lagged net income by $119 million, suggesting a $2.00/share or more drag on EPS in the future.

Exhibitor Industry

We expect Q3 domestic box office to end up 8 percent from a strong release slate and easy comps. Q3:12 experienced year-overyear decreases in the box office each month of the quarter, even though The Dark Knight Rises reached almost $450 million at the box office last year. We believe the larger number of blockbuster releases will drive year-over-year gains for the quarter, similar to Q2:13’s performance. Q2:13 ended up 7.8 percent year-over-year due to a strong June and May, up 17.9 percent and 11.4 percent respectively.

We calculated a weighted average growth of approximately 7 percent in Q2 across Cinemark’s (NYSE:CNK) Latin American markets. We estimate that international admissions revenue will comp lower than the market growth numbers due to increased theaters and higher reporting percentages incorporated into the market growth calculations.

We expect a very active M&A market to continue in 2013 and 2014 as the industry continues to consolidate. The transition to digital, IMAX (NYSE:IMAX), and 3D screens is helping to drive industry consolidation. Approximately 85 percent of screens have been converted to digital, and while most circuits have some portion of screens converted, a significant number (around 6,000, or 15 percent) remain unconverted. According to Carmike (NASDAQ:CKEC), there are approximately 40,000 screens in the US, of those, ≈ 20,000 are controlled by the top four exhibitors, ≈ 4,000 are controlled by the next 15 largest circuits, while the next 36 circuits control ≈ 3,600 screens, leaving over 12,000 screens owned by very small operators. Theaters coming to market fall into two buckets: (i) private equity owners, which are easier to predict due to their time horizon and (ii) family owned, which are harder to predict and usually come to market during generational transitions. Regal (NYSE:RGC) estimates that there are approximately 2,500 – 3,000 screens which would be attractive to the big four exhibitors at the right price. Attractive screens are modern (built in stadium seating era) and in stable or growing markets.

Michael Pachter is an analyst at Wedbush Securities.

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