In the years I have been writing on Seeking Alpha, I have penned more than 1,500 articles on stocks I own, equities I am considering, stocks I think are overvalued, and my general perceptions regarding the market and the economy. During that time, I have only written one article focusing solely on Netflix (NFLX). I talked about it in May 2011 when the equity was trading around $250, and the shares had rallied some 800% over the previous two years. I provided an outline as to why I thought the shares were significantly overvalued and the challenges the firm had ahead.
The stock continued its momentum for a while and hit $300 a share in the fourth quarter of 2011. Fundamentals then caught up with the stock, and it plunged to below $80 a share in early 2012. I had a short position in NFLX at the time the article was written, using deep-out-of-the-money long-term bear put spreads that ended up yielding almost 500% when I sold them in the first half of 2012. It was one of my best profits on any position in that year.
Since that time, I have not taken any position in the stock or written about it as a main focus. However, after its massive run over the last six or seven months -- NFLX has gone from $55 in late September to a current $215 -- it is time once again to take a closer look at the company, its valuation, and its business model. I am looking to employ in the near future a similar long-term bear put spread strategy as in 2011.
Valuation: The stock trades north of 500 times the EPS of 29 cents it produced in FY 2012, and over 150 times the EPS projected for this fiscal year. NFLX also trades at more than 14 times book value, and actually has had negative cash flow over the prior four quarters in aggregate. Analysts project the company will grow revenues just under 20% annually over the next two years. The stock also sports a massive five-year projected PEG of 8.0. Insiders have taken advantage of the recent rally to unload over 2 million shares in the last week.
Competition: Netflix's competition has increased since I wrote about it in May 2011, primarily from Amazon (AMZN). The problem with competing against the giant from Seattle is that it willingly sacrifices profits and cash flow to grow market share. This is not a good thing for competitors in any niche it decides to target, as it drives down your margins as you try to compete with it. Amazon also has the best technology infrastructure in the business, as it builds massive data centers and expands its web services to other Fortune 500 firms. That takes away an advantage Netflix has against DVD purveyor Coinstar (CSTR).
Amazon's film library has also expanded significantly over the last two years and now offers tens of thousands of movies and TV shows. It also is rumored to be working on a sub-$100 video set-top box. Microsoft (MSFT) is rolling out a new Xbox next month and has hired an ex-CBS executive to create original content as it moves deeper into video streaming. Netflix also has to compete with cable companies that are expanding their on-demand offerings. The company currently has a little more than $300 million in net cash on its balance sheet. Given that Netflix has little positive cash flow and continues to expend substantial capex expanding into new international areas and is starting to create it owns content, will it have the cash to continue to hold competitors like Amazon and Microsoft at bay?
Business Model: Other than competition, one of the main reasons Netflix does not deserve its lofty valuation is its business model. The company has shown that it cannot raise the price of its monthly service without suffering the ire and service cancellations of its customer base. In addition, with all the competition for content, I am doubtful the company will be able to grow subscriptions faster than content costs in the long run. This makes it a very cyclical business.
When Netflix has contracts in place for its content that stabilize costs, it can add subscribers and grow earnings. When content contracts expire and/or it needs to increase capex to create original content, costs soar and earnings come down. In some ways it is very similar to a steelmaker: costs that vary widely, leading to uneven earnings/cash flow growth. The difference, of course, is that cyclical companies do not get rewarded with valuation north of 150 times forward earnings -- and neither should Netflix.