One company that I poke fun at, from time to time, is Netflix (NFLX). Investors seem to keep coming back to the stock, even though the internal metrics of its business model are quickly devolving from growth-mode down to just-hanging-in-there-mode. The stock is priced for peak perfection with not a cloud in the sky. This is unsustainable, and it is proving to line up a fantastic short-sell opportunity to cash in on reality.
Don't get me wrong, video streaming has taken off in a huge way. The number of households using their television to watch paid and free streaming content from the internet keeps growing in leaps and bounds. But NFLX's problems don't lie in its user base, they lie in the way it has structured its business.
Cash-Flow, Real Growth, and Management Performance - Not Pretty
A big part of their problem comes from cash-flow. Cash-flow is a killer for many businesses that might have a fantastic product or service, but can't afford to bring it to market on their upfront costs and keep operations running. NFLX has had a cash-flow problem since before their stock topped out at a ridiculous $304 per share in 2011.
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This stems from the fact that they have been growing the liability side of their balance sheet at a blistering pace, while not translating that over to net value for their shareholders. Liability growth has outpaced book value growth by almost 1800% over the past 10 years.
Netflix's "growth" story is one of those funny ones, like Amazon. If you decide to take it at face value - the number of subscribers they have paying for their service - things are looking pretty good. If you dig a little deeper, cracks start to appear in the Netflix long case.
Margins have been systematically declining for a long time now. Even while we have seen revenues growing in huge jumps, the internal metrics of how efficiently NFLX is running its business are bleeding off the other way. I am never one to say that a trend in one direction will remain a trend forever, but Netflix has made no indication of major, systemic changes to its business model that will reverse this slow-motion car crash:
Netflix's asset utilization has trended negative compared to its historical performance - dismally so. Shareholders should be all torches and pitchforks with management performance like this:
Furthermore, because digital streaming is a low-capex business (relative to the many other types of businesses that new capital can go into) companies, like Netflix demonstrated, could churn out nice margins, once upon a time; it has encouraged more and more entrepreneurial capital to flow into new ventures - i.e. Netflix doesn't have an economic "moat" business, and it's attracting major competitors, including Amazon Inc. (AMZN).
Since It's Not Genuine Growth, Is It Value?
In a word: No. Netflix's forward P/E for Dec 31, 2014 is at a whopping 62.59. Its current trailing P/E sits well over 500. Investors are paying for an impossible amount of growth, at current prices, to get Netflix down to even conservative "growth" levels. A note: For anyone intending to comment that "P/E doesn't matter", I encourage you to pull up one of tens of thousands of news articles from, oh, the late 90s and have a peek.
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Cash from operations is negative and has continued to trend lower as seen above. This is not growth, and it is not value. Were Netflix to declare bankruptcy today, investors would be lucky to receive $10.00 per share based on its actual book value. Despite a very brief swing between price growth rates and book value growth rates, the disconnect is wide again. At this point, we are asking "how high of a premium are investors willing to pay for these small net assets and declining revenue growth and margins?".
Our good friends over in the sell-side community, despite having abysmal performance at every turn on this stock, seem to have a bit more heads on their shoulders these days (either that or the latest gap in prices hasn't provided enough time yet for them to justify the move after the fact and issue new guidance).
As of today, the analyst picture is looking pretty neutral/slightly bearish - Most analysts are currently recommending a "hold" on NFLX and an average price target of $124.46 - miles below where we are now.
The share price popped up over 35% after hours on an earnings announcement that basically was +$30 million or so relative to the existing consensus, and an exclusive distribution deal with Disney. Big news, indeed, but a tough nut to crack with their burgeoning content liabilities, at a whopping $5.6 billion dollars. Investors shook that off in favor of the growth story and have driven the stock up to over 80% off of its lows of last year.
So, What Happens With Netflix Stock
There is still upside from here. Yes, that seems to be in complete contradiction with everything you have just read before this, but the fact of the matter is that market participants are not rational creatures. They are highly subjective and emotional, as has been demonstrated time and time again. Valuations are useful in that they determine the level of optimism or pessimism relative to the underlying, tangible aspects of the business that investors are trying to own or sell.
It is almost impossible to pick a downside price target on Netflix using strictly fundamental measures. The internal trend of ROE, ROA, and decline in margins make traditional valuation immensely difficult; they put the net value for NFLX far, far below current levels and at a shockingly depressed level.
Here's why I'm expecting more upside in the near future:
There are a few open gaps that make ideal price targets for a last stab for NFLX's retracement. The .618 Fib retracement lines up almost perfectly with the open gap at $208.71 from way back in Sept 2011. This should act as a magnet for the price once this consolidation period has concluded.
The consolidation occurring right now after the earnings gap is a very high-probability price pattern known as a contracting triangle. It always precludes the final move in a trend - the last burst of consolidating conflict between the bulls and bears, before breaking out in the direction of the larger trend - in this case, to the upside. The participation level in this stock is such that the triangle is forming almost perfectly.
So, I'm calling for a break out from this pattern with a price target of $208/share that should be reached very swiftly. Traders can target this for a $40 gain, while longer term investors who were lucky enough to get in on this stock sometime late last year can take this as an opportunity to lighten up your holdings of NFLX and search for better deployment for investment capital.
Where Do We Go From There
It is tough to say. Once this price target is reached, there will certainly be a correction of the larger move off of 2012's lows. I think that the overall shake-out in investor participation in tech stocks on the whole is just underway (see: Apple and Amazon). The psychology and flood of investor money into "tech will save us" needs to unwind, just as the real estate psychology of the mid 2000s, the commodity psychology of the late 2000s, etc. all needed to.
As such, I think there is another major leg down approaching in Netflix in the longer term. For now, shareholders are completely willing to ignore the systemic balance sheet issues and internal declines of actual business performance, because the share price has been rallying for 6 months. Once another decline sets in, these issues will move to front and center, and Netflix will either change its business model or lose out to a competitor who is willing to take things in the right direction - this is the nature of business that serves the consumer.
My final price target on NFLX might seem ridiculously low right now, but I believe it places Netflix into a conservative enough valuation that the risk premium on these issues would be worth paying, and the actual return on capital and metrics within the business model are at more level-headed premiums. Here is where I think Netflix stock is headed in the long term:
Much like many other tech stocks out there today, Netflix has a great idea whose growth levels have been ramped up too far, too fast, and is running an unsustainable business model. Systemic fundamental changes are needed to reset the internal declines on the company's performance. A large downside move for Netflix stock, which I believe is coming fairly soon after we see another leg up, will be a good kick in the pants for management and will get shareholders putting the screws to the people who carry Netflix forward. At that time, I think Netflix will actually have more uncertainty behind it than exists today, and it will be a superior investment.