Many investors have lost a lot of money betting against Netflix (NASDAQ:NFLX), however, this should come as no surprise considering that the stock is up more than 350 percent during the last 12 months. I will prove in this article why, at a stock price of $253 and a market capitalization of $14.5B, I think Netflix is an exceptional short idea.
THE COMPETITION NETFLIX DOES NOT WANT YOU TO KNOW ABOUT
Netflix enjoys a huge market share in paid content on the internet; however, the competition has been gearing up and pressuring the company in many ways. Up until recently, the company was almost unopposed and it could add members at a very rapid rate. Now we have companies such as Hulu and Amazon (NASDAQ:AMZN) joining the race in order to get a piece of the pie, which is why the growth rate of Netflix has somewhat slowed down. Apple (NASDAQ:AAPL) is barely getting its feet wet and some cable companies are testing their own streaming, which may pressure Netflix further. Moreover, Google's (NASDAQ:GOOG) YouTube is testing a model where users pay a small fee to view some movies, but the company's library mostly consists of older movies for the time being.
While the competitors I just mentioned are a huge threat to Netflix, they are not the ones the company should be worrying about. The real threat is the thousands of free movie streaming websites, which offer an even greater amount of content than Netflix. Since I know that I will receive a lot of criticism for writing this, I will actually demonstrate (using two popular movie websites as examples) that it is possible to stream any movie or TV show we want for free. This proves that Netflix has no competitive advantage, which should have those who own the stock very concerned.
I will use the new movie "Olympus Has Fallen" (released in theaters March 2013) as my first example. Now, you could get a Netflix subscription and just stream the movie, or perhaps, you could not get a Netflix subscription and still stream the movie. I think most rational people would go with the second option. There are literally thousands of movie websites out there that allow free streaming. In this example, I will use the popular movie website called SolarMovie to demonstrate my point. You simply type in Olympus Has Fallen in the search box above and this is what you should get:
As can be seen, there are a bunch of links, all of which allow you to stream the movie (no need to fill out any surveys). In this particular example, I just clicked on the sockshare.com link. After clicking this link, you will get a page that says "play now" or "stream in HD," click the first one ("play now"). Once you click that link you will see this:
Finally, click Close Ad and Watch as Free User. Maximize the screen and enjoy the movie!
Want to watch the movie on your big-screen TV? Just go online and order a cheap HDMI cable which allows you to connect your laptop to your TV. That is all there is to it.
Streaming TV Shows
Streaming TV shows is just as easy as streaming movies. I will use the Netflix original series "House of Cards" as an example. Remember, Netflix paid $100 million to production house Media Right Capital for the exclusive rights to stream this program to its subscribers. I guess these "exclusive rights" are not that exclusive after all. We will also use a different website called VODLY.TO; however, the website I used in the first example also offers the same content. If you search for House of Cards, this is what you should get:
As can be plainly seen, the complete first season is available for free streaming (season two has not been released yet). Just click on the episode you want to watch and stream it like the movie example above. It could not be any simpler.
It is websites such as the ones I used in my two examples that are a significant threat to Netflix. I personally know dozens of people who have cancelled their Netflix subscriptions and now just do free streaming. This trend will continue in the future since the younger generations are more tech-savvy.
ACCOUTNING RULES HELP NETFLIX HIDE MASSIVE LOSSES
In recent years, Netflix's management has been attempting to disguise the company's terrible fundamentals by boasting about things such as "subscriber growth" and "new content deals" they have made. Personally, I try to ignore this managerial propaganda by reading the SEC filings in order to analyze the company's true profitability and financial health.
The first thing I want to examine is Netflix's deteriorating profitability. I will focus on the data from 2007 onwards, because this is the year streaming was introduced. In the table below, I provide the annual revenue, net income and free cash flow numbers over this time period:
Just by taking a quick glance at the numbers in the table, we can see that Netflix used to be an enormously profitable business. However, even as early as 2010, there were some red flags that would have told us that the good times would not last long. In order to fully understand why Netflix was so profitable in the past, and why this kind of financial performance is not likely to repeat, we must first study the way the company acquires and amortizes content.
This table compares the amortization of content to the actual cash spent to acquire the content:
Note that from 2007 through 2009, the two amounts parallel each other closely, which makes sense: the amount Netflix spends to acquire content should be amortized over time. In fact, over these three years, the amount amortized is 89.4 percent of the total amount spent acquiring content - again, what one would expect, given that amortization should lag cash outlays in a rapidly growing business.
However, starting in 2010, these two numbers diverge sharply, as Netflix began paying large amounts for content. In 2010, acquisition costs rose just over 106 percent (from $257M to $530M), yet, strangely, amortization of content library rose a little less than 37 percent (from $219M to $301M). Things got even worse in 2011, when acquisition costs rose close to 354 percent (from $530M to $2.41B), while amortization of content library rose less than 165 percent (from $301M to $796M).
The table below shows what would happen if we apply the 89.4 percent average ratio between amortization and cash outlays from 2007 - 2009 to the 2010 - TTM cash outlays:
To put all of this in perspective, recall that Netflix's net income in 2010, 2011, 2012 and during the most recent 12 months was $161M, $226M, $17M and $48M, respectively. If amortization was not lagging so much, Netflix would have reported enormous losses every single year.
One of the main reasons net income plummeted in 2012 and during the first half of 2013 is because amortization is finally catching-up with the actual cash outlays for content. As this trend continues, investors should expect net income to continue deteriorating, and will most likely be negative in future years.
There is also evidence that Netflix's historical free cash flow was inflated as well. For instance, Netflix had record free cash flow in 2011 of approximately $183M. The company spent $2.32B to acquire new streaming content that year, however, only $857M of this amount was the actual cash outlay for this content (the rest, or about $1.46B, became a liability on the balance sheet called "current content liabilities" and "non-current content liabilities").
As can be seen from the cash flow statement above, Netflix was able to increase its "net cash provided by operating activities" just by adding liabilities to the balance sheet. Had Netflix only used cash to purchase streaming content, its free cash flow would have actually been negative $1.28B in 2011.
Even the 2012 free cash flow, which was negative $67M, is a lot worse than it first appears. If we look at the cash flow statement below, we see that in 2012 the company acquired $2.52B of streaming content; however, streaming content liabilities also increased by $762M, meaning that the actual cash outlay for this content was only $1.75B. In other words, had Netflix only used cash to purchase this content, free cash flow would have actually been negative $829M.
Again, just by increasing liabilities on the balance sheet, Netflix has been able to report free cash flow that is better than it really is. However, there is an old Wall Street saying: "No tree grows to the sky." Likewise, no liability can keep increasing forever - eventually Netflix must pay it off (with cash that it does not have). And since the company does not have the money to pay off these liabilities, its financial health will continue to weaken.
BALLOONING OFF-BALANCE SHEET LIABILITIES
If we only looked at Netflix's balance sheet, we would come to the conclusion that the company is in decent financial health. For example, as of June 2013, the company had close to $1.1B in cash and short-term investment, total liabilities of only $3.4B, of which $500M is debt. In fact, more than 72 percent of the company's liabilities have to do with the money owed for the purchase of streaming content. However, in order to get a clearer picture of Netflix's true financial health, we also must analyze the billions in liabilities kept off-the-balance sheet.
As of June 2013, Netflix had about $2.4 billion in content obligations on its balance sheet, however, those willing to dig through the footnotes will realize that Netflix had total content obligations of close to $6.4 billion. This is because about $4.0 billion in content obligations are held off-the-balance sheet.
The reason these obligations are not reflected on the balance sheet is because they do not yet meet the content library asset recognition criteria. This is because either the fee is not known or reasonably determinable for a specific title or it is known but the title is not yet available for streaming to members.
Netflix has also entered into certain license agreements that include an unspecified or a maximum number of titles that the company may or may not receive in the future and/or that include pricing contingent upon certain variables, such as theatrical exhibition receipts for the title. Since it is unknown whether the company will receive access to these titles or what the ultimate price per title will be, such amounts are not reflected in the commitments described above. However, it is important to note that such amounts are expected to be significant and the expected timing of payments could range from less than one year to more than five years.
Netflix also has approximately $151M in operating lease obligations, which should be capitalized and treated as debt. Since the company only takes into account the minimum future lease payments for these facilities, this number is almost certainly understated. I expect operating leases to increase in the future as the company continues expanding.
The final off-balance sheet liability that must be mentioned is the $166M in other purchase obligations. These contracts are primarily related to streaming content delivery, DVD content acquisition and miscellaneous open purchase orders.
When taking into account all of Netflix's liabilities, its financial health no longer looks that great. Considering that profitability is deteriorating, and will continue to do so, the company simply cannot pay off these enormous liabilities without taking on additional debt (increasing risk) and issuing more stock (causing dilution).
THE VALUATION IS CRAZY
Due to Mr. Market's irrational exuberance, Netflix's shares have more than tripled in price over the last 12 months. However, by any measure, Netflix's valuation is extremely rich. Some investors value the company based on its earnings (or projected earnings), however, as I have already shown, these earnings will continue to decline because amortization expense is rising. Others value Netflix based on its 38M subscribers, however, these subscribers are not worth very much since they can get the same content elsewhere for free. In fact, we have already seen evidence of this lack of customer loyalty back in 2011, when a price hike caused the company to lose close to one million subscribers. Perhaps one of the only ways to value Netflix is on a price-to-sales basis. As of this writing, Netflix had a market capitalization of approximately $14.5B and TTM revenue of $3.9B, giving us a price-to-sales ratio of around 3.7x. However, even this method of valuation depends on the company's long-term earnings power. In other words, companies with higher profit margins deserve higher price-to-sales ratios, and vice versa. In reality, no matter which valuation method we use, Netflix still looks overvalued. In short, the stock is priced for perfection, and any misstep would likely trigger a huge selloff.
SUMMARY & CONCLUSION
Netflix has absolutely no competitive advantage, because all of the content it currently offers (and much more) can be streamed online for free. Furthermore, in the past Netflix was able to take advantage of accounting rules to mask its deteriorating profitability. These same accounting rules have also allowed the company to hide billions in liabilities off-the-balance sheet. Once we take all of these things into account, it becomes obvious that the Netflix is grossly overvalued. This stock is one of the best short-selling opportunities of the year!
Disclaimer: To be clear, I am not suggesting that people should cancel their Netflix subscriptions and choose to stream movies and TV shows for free. This is illegal! The websites shown in this article are just examples to prove how easy it is to steal content. This is a big problem for companies such as Netflix that are forced to pay a lot of money to buy this same content. I also encourage readers to report these illegal websites to the federal authorities to have them shut down.