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Netflix’s poor growth and risky new strategy pose a big risk for the company

Investors have rapidly sold shares of Netflix stock in after-hours trading since it announced earnings today (pdf), worrying about uneasy signs that the movie subscription service is making a risky gamble. The company reported that it spent more money to operate than it earned in the third quarter, and will do so for a while to come. It also saw earnings per share of $0.12, more or less in line with expectations.

According to a letter sent to investors, Netflix saw a negative free cash flow (FCF) of $20 million during the third quarter, which far outstripped net revenue of $8 million. The company blamed the discrepancy on costs associated with developing exclusive content—a key piece of its plan to differentiate itself from similar services like Amazon Prime and iTunes. In its earnings release, CEO Reed Hastings and CFO David Wells wrote:

As we’ve highlighted, our movement into original programming will require more up-front cash payments than our typical content licensing agreements, beginning in Q4 and increasing in 2013. So, due to initial cash payments for originals, in addition to other cash payments for content in excess of P&L expense, we anticipate negative FCF for several quarters.

But it’s unclear that the already struggling company can support the risky bet. Investors have been worried that the company can meet its debt commitments—$400 million out of a total $798 million cash on hand—since last year. But its growth prospects may be unhealthy: sales grew by less than 2% since last quarter. While it added subscribers during the quarter, its new domestic subscriptions were at the bottom end of estimates. One can argue that Netflix’s new strategy will eventually bring it a whole new subscriber base and consumers may love it, but there are many signs that the company is floundering right now.

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