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Netflix (NASDAQ:NFLX) has generated great gains for those investors who bought before January 23rd of this year, when the stock price was around $100 per share. It seems like many investors have hopped on the optimism bandwagon, since it was a great opportunity to buy at those levels. Not anymore.

First off, let's analyze the company to understand what its strong and weak points are.

Revenue distribution

This is the distribution of revenue per business unit:

(click to enlarge)

Source: Netflix's Q4 2012 Report

As you can see, Domestic Streaming keeps being the pillar of Netflix's revenue driver, but International Streaming will be the key growth driver for the following years. The marketing efforts have been slowly paying off, as International Streaming revenues have doubled in just a year.

Domestic DVD's are slowly doomed to failure, and represented 10% less revenue during 2012 (compared to the other two business units), and will be replaced entirely by Domestic Streaming in the following 3-4 years, at most.

Costs per paying customer are dropping in the International Streaming segment

(click to enlarge)

The graph above shows the declining cost of acquiring and maintaining customers for Netflix. Domestic streaming and Domestic DVD's costs per customer has been holding steady around $15-$16 per quarter per customer.

These costs include the cost of revenues, content acquisition costs and marketing expenses. These costs are especially important in the International Streaming market, where the costs per customer have dropped from $47.67 to $33.69 for the last quarter of 2012. This tendency of declining costs per customer bodes well for Netflix, which may aim to have costs per customer around the $15 mark in the coming years.

International Expansion will continue to create losses in the short-term

Netflix has seen the tremendous potential that the international markets have in bringing in more revenue and has correctly, in my opinion, began penetrating markets aggressively with marketing promotions, discounts and low entry prices, like the promotion it offers in Mexico where customers get one month of service free, which in my opinion is a great way to gain potential customers with a low-cost strategy, as it raises brand awareness and aims to keep those customers for life.

Revenues per customer have been increasing in the international streaming business unit

(click to enlarge)

As you can see, the domestic streaming and DVD business units have reached a "top" in its pricing strategy, especially when you consider the streaming competitors that exist and the other streaming alternatives that keep coming to take away Netflix's market. The company's opportunity is in the international business.

Netflix will continue to try to keep its domestic DVD business alive because of its contribution margin:

(click to enlarge)

Netflix's big problem: tiny operating margins

Netflix has been struggling to keep its operating or EBITDA margin above 13.1% (achieved in 2010), and I see no clear catalysts of margins materially raising above levels achieved from 2009 to 2012. Its margins were in the 11.5% to 13.1% range, and the margin was a measly 1.4% in 2012:

(click to enlarge)

Economic Value Added

Netflix has had a history of adding between $111 million to $321 million in its best year, 2011, but failed to deliver due to the reasons described above and effectively destroyed $960 million in value, not being able to cover its cost of capital.

Piotroski's F_Score

Below are the results for Netflix's 2012 results via the Piotroski's F_Score, which brings to light if a company is weak or strong based on 9 binary results, comparing last year's results to the most recent period, 2012.

This score is based on: return on assets, cash flow from operations, accounting red flags (having more earnings than operating cash flow), liquidity, equity issuance, leverage, asset turnover and margins. Below are the results:

1. ROA

1

Positive return on assets

2.CFO

1

Positive Cash Flow from Operations

3. ΔROA

0

Decreased return on assets

4. ACCRUAL

0

Accounting red flags

5. ΔLEVER

1

Decreased its interest-bearing debt

6. ΔLIQUID

0

Worse current assets to current liabilities ratio

7. EQ_OFFER

0

Issued more equity

8. ΔMARGIN

0

Decreased net margin

9. ΔTURN

0

Decreased asset turnover

As Piotroski's analysis points out, a stock with a score of 3 or less is weak, and I recommend shorting this stock while the price and optimism for this stock is high.

Netflix's Cash Flows are weak

Figures expressed in billions of U.S. dollars.

2008

2009

2010

2011

2012

Operating Cash Flow

$0.284

$0.325

$0.276

$0.318

$0.017

Financing Cash Flow

($0.177)

($0.085)

($0.100)

$0.262

$0.006

Investing Cash Flow

($0.145)

($0.246)

($0.116)

($0.266)

($0.246)

($0.037)

($0.006)

$0.060

$0.314

($0.223)

As you can see, the best year for Netflix was when it got a huge boost from issuing more common shares. I would be wary of buying a company that offers no dividends, has a hugely volatile stock and keeps diluting its shareholders. I'm not saying it's wrong, but if you base your operation around constantly issuing debt and stock to present mildly positive cash flows, either something is very wrong, or you are incurring in huge investments, i.e. the company's international expansion, so I will almost let this one pass.

DCF Valuation

As usual, I will portray three scenarios.

First off, the assumptions for the "business as usual" scenario:

  • The international expansion goes well, but domestically the company grows less every year as the market saturates, creating annual revenue growth that went from 13% in 2012 to 15% per year until 2017, where it grows at a 5% rate to perpetuity.
  • Operating margins stay at 11% for 2013 and 2014, then the economies of scale created by lower marketing costs and higher number of customers in international markets helps the company achieve 12.5% operating margins until 2017, and due to competitors gaining more market share, Netflix's operating margins stay at 10% to perpetuity.
  • Investing and financing cash flow are kept at 2011 levels, as they have shown little variability in the past four years and I have yet to visit the future.
  • Price target: $149.82

"Optimistic" scenario:

  • International expansion is a big success, and domestically, both streaming and DVD subscribers keep piling up, creating an annual revenue growth that went from 13% in 2012 to 25% per year until 2017, where it grows at a 10% rate to perpetuity.
  • Operating margins grow from 1.4% to 13% to perpetuity, ignoring competitors possibly entering into a price war and customers having more streaming options available at cheaper prices.
  • Investing and financing cash flow are kept at 2011 levels, as they have shown little variability in the past four years.
  • Price target: $217.06

"Negative" scenario:

  • The international expansion does not go as well as planned, and annual revenue growth stays at 13% per year until 2017, where it grows at a 5% rate to perpetuity.
  • Operating margins grow from 1.4% to 11% in 2013, and drops 1% every year until they reach 8% in 2017 and to perpetuity due to increased competition, price wars and substitute products entering the streaming content industry.
  • Investing and financing cash flow are kept at 2011 levels, as they have shown little variability in the past four years.
  • Price target: $66.99

(click to enlarge)

All of these scenarios can be summarized below given the distinct probabilities I assigned to each one:

Business as usual

Share Value w/DCF Valuation

50%

$ 149.82

Positive outlook

Share Value w/DCF Valuation

35%

$ 217.06

Negative outlook

Share Value w/DCF Valuation

10%

$ 66.99

Target Price

$ 157.58

Upside potential

-16.2%

Final Thoughts: Avoid or short Netflix

Given that my target price for this stock for December 2013 or earlier is $157.58, I will build a short position using short June calls, as they provide more ROI and have a higher breakeven point than longer-dated short call spreads.

In this case, I recommend starting a position that looks like this:

Sell to open 1 NFLX June 2013 150 calls @46.50

Buy to open 1 NFLX June 2013 200 calls @19.13

This will give you a credit of $2,737 per contract (which is your maximum profit), requiring you to tie up $2,263 per contract, which is your maximum loss if you hold until expiration and prices remain above the $180 area.

This offers a ROI of 54.7% if Netflix's stock is below $150 per share in the third Friday of June, but I recommend closing (buying back your short call spread) it earlier, when the price of the stock touches $150.

If you have any thoughts or comments, feel free to use the comment section below.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in NFLX over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Netflix: A Good Company, But A Terribly Overpriced Stock