Netflix, Inc. (NFLX) Warning: 3 Red Flags in The First Quarter Report

Netflix, Inc. (NFLX)Shares of Netflix, Inc. (NASDAQ:NFLX) popped 25% on strong first quarter results. But long-time bear Michael Pachter points out three holes in the bull thesis.

Subscriber churn

“They’re [Netflix] borrowing from the last two quarters because people are accelerating their joining. I think these guys are set up for a huge problem in September.” Michael Pachter

Netflix, Inc. (NASDAQ:NFLX)’s bet on original programming seems to be paying off. During the first quarter House of Cards drove more than 2 million new U.S. streaming subscribers, topping management’s guidance.

But Pachter warns that original content is stealing from future subscriber growth. Netflix is going to be challenged to grow in the back half of the year because their exclusive content is less compelling. Falling subscriber growth could be a negative catalyst in upcoming quarters.

In some ways the effects of Netflix, Inc. (NASDAQ:NFLX)’s original content initiative resembles America’s Cash for Clunkers program in 2009. The stimulus measure did little to change the total demand for vehicles but only stole from future consumption.

high margins

“Content costs only increased by about a third of the revenue increases on domestic streaming. That’s not sustainable. The content guys will not take one third of revenue for content.” Michael Pachter

In Netflix’s first quarter results, revenue increased $49 million quarter-over-quarter while content costs increased by only $16 million. In Pachter’s view that’s unsustainable.

To compete, Netflix, Inc. (NASDAQ:NFLX) has to offer compelling content, of which prices are soaring. Pachter estimates streaming content deals will cost Netflix $2.5 billion in 2013, up from $300 million in 2010. Recent multi-year agreements with Disney and Warner Brothers alone could cost an estimated $320 million in addition to the cost of original programming like House of Cards and Arrested Development.

Margins will likely further contract as new deep-pocket rivals entering the marketplace.

Coinstar, Inc. (NASDAQ:CSTR) partnered with Verizon Communications Inc. (NYSE:VZ) to launch its own streaming service in March. The same week the company announced it would issue $350 million in new debt. Investors think this can only mean one thing: Coinstar, Inc. (NASDAQ:CSTR) is building its war chest to challenge Netflix. Analysts expect the company will spend heavily to secure streaming rights from Time Warner Inc. (NYSE:TWX) and Epix.

More concerning is the 400-pound gorilla of eCommerce:, Inc. (NASDAQ:AMZN) .

Barclays estimates Amazon will spend $1 billion expanding its video library driving up content costs. The company is also undercutting Netflix, Inc. (NASDAQ:NFLX) prices as a, Inc. (NASDAQ:AMZN) Prime membership is $15 cheaper than a Netflix subscription annually.

CEO Jeff Bezos has no problem sacrificing short-term profitability for long-term gains. That may be acceptable for Amazon shareholders. Streaming video only accounts for a tiny faction company’s total revenue. But having a non-profit for a rival spells disaster for Netflix, Inc. (NASDAQ:NFLX).

International losses

“They’re [Netflix] losing money on every single customer, but making it up in volume.” Michael Pachter

Bulls often argue that Netflix is well positioned for massive growth internationally. Last quarter, the company grew international streaming revenues by over 227% to $142 million and the company is looking to expand into new markets including China, Japan, and India.

But bears caution that while top line growth is impressive, the company lost $76.9 million internationally during the first quarter. Content costs increased 80% to $165 million. The company is paying outrageous prices for programming internationally and isn’t gaining much traction. The faster the company grows, the faster losses pile up.

Foolish bottom line

Perhaps the biggest problem facing Netflix, Inc. (NASDAQ:NFLX) is how to fund rising content costs and expansion. CEO Reed Hastings has three options:

1) Ax programming: Already we’ve seen Netflix cut content from Disney, Sony, A&E, and History Channel. The problem with this strategy is that members may cancel their subscriptions and move to competitors that offer more content.

2) Issue debt: In January, Netflix issued $500 million of debt at 5.4%. The problem is the company’s finances are already stretched. Standard & Poor’s already rates the company’s debt as junk and could lower that rating if the Netflix’s balance sheet continues to deteriorate.

3) Raise prices: Netflix has already proven this isn’t an option. The last time the company raised prices, customers revolted.

Of course these problems don’t just plague Netflix but also competitors entering into the business like, Inc. (NASDAQ:AMZN), and Coinstar, Inc. (NASDAQ:CSTR). Few entry barriers, rising content costs, and low prices are glaring hole in the business model. While most of the focus will remain on the online providers, the real winners in the streaming wars may well be CBS, Disney, and Time Warner Inc. (NYSE:TWX).

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