Toppling Netflix Bulls With a Strategy

 | Jun 14, 2013 | 1:00 AM EDT
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One helpful tip offered by a personal hero of mine, Sun Tzu, on toppling an enemy is this: make them appear as if you are absolutely on their side while internally plotting how to overthrow them. So, here is how to put that logic into practice in a bull versus bear debate on a stock. 

I will actually present the bull case on Netflix (NFLX)! At first pass, it's very hard to not become all warm and fuzzy on Netflix as an investment opportunity. Hey, the stock is up 125.67% year to date. That immediately fills the qualifier that the market must know something the investing faithful do not pertaining to the company's future. If you look into the company's financial results, there is an array of reasons to be encouraged. The reasons include an increasing subscriber count and a first quarter bottom line that came in significantly better than expected and ripped the faces off the shorts.

Getting fancier, there is even more to like on your favorite streaming video service:

  • Intends to increase to 15% of its total licensing budget (from 5% currently) for original content creation. Netflix has hit numerous original content homeruns, so surely this initiative would seem to be a winner, winner chicken dinner going forward.
  • Rivals such as Amazon (AMZN) and Hulu are so far behind Netflix in subscriber count and original content that it's clear they are collectively competing for the second position. When this is the case in a sector, the leading company is better able to hold onto its competitive advantage.
  • Deal to show Disney videos immediately after they are in the theater starts in 2015, which is exciting (will foster more family watching and greater affinity for the brand, as well as creating a new class of people growing up watching streaming content instead of TV).
  • Stock popped 24% on its April 23 earnings release day, indicating at least then that the stock continued to be under owned (likely as the company remained un-loved).
  • Revenue growth bottomed in the second quarter of 2012 at 13%; it was 18% in the first quarter of 2013.
  • There have been two consecutive quarters of re-acceleration in average paying subscribers.
  • In the first quarter of 2013, the domestic streaming contribution margin rose to 21% from under 20% in the first quarter 2012.
  • International streaming is 20% of the streaming memberships; obviously the brand is gaining interest amid a push abroad. In two years' time, Netflix has added seven million international subscribers.

It's time to drop the sneak attack on the bulls, because frankly, the reasons to be negative are much stronger than the reasons to be positive. The stock looks severely overvalued when cutting beneath the fluff of increasing subscriber counts and a robust 1Q13 earnings beat. Here is the real deal:

  • Netflix's historically strong quarters are the first and fourth. In the first quarter of 2013, the company had an interesting step lower in content costs alongside a strong ramp in subscribers. In terms of subscribers, it was probably due to positioning ahead of new program releases shortly. This means that once the demand is satisfied, the churn rate could increase (customers roll off as customers).

 As for content costs, Netflix is headed down a path of higher costs to create differentiated programs and build out abroad; for example Amazon has increased by 3x the number of streaming offerings it offers to Prime members, and Netflix will really have to up its game to stay out in front. The market has priced in rosiness, not approaching clouds.With a big reliance on original content comes increased risk. This risk was on display recently as the stock took a hit on poor "Arrested Development" reviews.

  • The market looks to be valuing the stock as if the addressable market for Netflix is 90 million households, near the top end of a 60-90 million management goal. I think that is a too high.
  • The company was adding three million subscribers a quarter prior to its 2011 price increase, but has since been adding around two million a quarter. The read: the company's product is not viewed as a must have by consumers (still love their traditional TV). And any further price increase will be met with a spike in customers lost. My sense is that Netflix will be forced to raise prices in 2014 in order to help cover content creation and other licensing deals.
  • DVD business, which is being de-emphasized, has a 47% contribution margin versus streaming at 21%. A lower margin business is increasing as percentage of sales.
  • Is a company boasting $4.3 million in total assets deserving of a $12.5 billion market cap?
  • Quite concerned on the company's cash flow (it's negative). Netflix is paying out more to secure content than is coming in from a cash perspective. I think the company will be forced to raise even more debt to fund its future, no good on a business that is far from high barrier to entry.

If charts are your thing, peep at these graphical pieces of amazingness. Your top thoughts should be: (1) why is this company not generating operating cash despite double-digit percentage revenue growth; (2) the first quarter spikes in revenue and gross margins appear unsustainable (this is when you can receive an unfortunate surprise comes earnings season as an investor) given the downtrend in place from prior quarters (which suggests greater competitive pressures.


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