In October 2012, I wrote an article encouraging investors to load up on shares of Netflix (NFLX) at $65.00 a share. As of this morning (October 22nd), I closed out the last of my position at $353.17 for ~440% profit. No matter what the bulls say, Netflix seems to have peaked post earnings, and is now beginning "the decline stage" of what is becoming a cyclical trend. I am confident that Netflix's shares have reached their peak, and will underperform over the coming months due to several key elements. The "euphoria" surrounding Netflix's current share price, presents an exciting opportunity to short the stock with a compelling risk/reward tradeoff and strong downward pricing pressures.
Netflix primarily offers a streaming video on demand service, having previously been a DVD rental business. The firm offers its streaming service to families, with its extensive library of children's programming, while also appealing to teenagers and young adults looking to watch past seasons of How I Met Your Mother or Arrested Development. Its breadth of content and recommendations software has allowed the company to generate a large, loyal subscriber base. In this sector, Netflix has encountered competition from Amazon's (AMZN) Prime streaming service, and Hulu's streaming platform.
Netflix's offers another service which complements the streaming business. Its flat rate DVD mail rental service allows its customers access to a much broader content base than its streaming service would, while allowing a degree of flexibility in how consumers watch Netflix's products.
The Drivers Behind The Current Share Price
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It doesn't take a genius to realize that Netflix has crushed the market recently. Over the last twelve months, the company's stock has returned a monthly geometric average of 14.27%, far in excess of the 1.70% monthly return generated by the S&P500, even though any fund manager would be more than satisfied with a 1.70% return. It was also the best performer in my portfolio, solidly beating Nokia's (NOK) return of 8.57% monthly. Therefore, Netflix has managed to easily outpace the market in a time of high growth.
Netflix has maintained a constant upward trend since the end of October 2012, the first serious price jump coming on the back of vastly improved earnings in Q42012 (reported in January), trouncing analysts' expectations. The most notable difference was over the profit of 13 cents a share, which was in contrast to the expectation of a loss of 13 cents a share. Netflix managed to generate a profit due to high subscriber growth of 3.86 million (2.05m domestic, 1.81m international), whilst cutting operational costs through a variety of methods including moving its data centers to remote servers.
April was also a notable month due to the exceptional first quarter Netflix posted in 2013. Once again, Netflix's profit per share far outpaced analysts' estimates, coming in at $0.31, versus the consensus of $0.19. Its profit exceeded expectations primarily through continuing solid subscriber growth, as the subscription service gained a further 2 million domestic users, on the back of several high profile additions to Netflix's library including the US TV series, House of Cards. Many credit the company's rapid growth with the broadening of its core content, an issue that management targeted as a priority in 2012.. The shares shot up some 30% further on the back of the 1Q earnings report.
Netflix has managed to maintain subscriber growth throughout the year, resulting in a $0.52 earnings per share, in the most recent quarter, a year-on-year increase of $0.39 on the $0.13 EPS recorded in 3Q2012. Therefore, clearly over the last year management have managed to deliver meaningful value to shareholders.
Subscriber Growth Unsustainable
Netflix currently has just less than 30 million subscribers (29.9 million), having just overtaken HBO which has 28.7 million, and is testament to their strong subscriber growth over the past year. Having said this, investors that expect to see continued subscriber growth of 8-10 million people a year, will be disappointed. Analysts estimate that Netflix will only gain around 20 million more domestic subscribers over the next five years, as Netflix's subscriber base is expected to grow to ~50 million in 2017.
The company faces several headaches in expanding interest among US customers. Firstly, customers are still only using Netflix as an addition to their TV service, whether it is Comcast (CMCSA) or some other service, and this trend does not look likely to dissipate. Therefore, Netflix might face problems in the future as these companies are starting to allow online streaming and online access to their content. Although this is a relatively new concept and in its early days, streaming options such as HBO GO offer subscribers access to much or all of the content that would usually be accessed through the TV. I firmly believe that this will offer significant competition to Netflix going forward. Sky (OTCQX:BSYBY) has already demonstrated through Sky Go the popularity of these options with consumers.
Cost Increases Ahead Due To Coverage And Rising Competition
It is quite clear that Netflix is in the best position to bid for TV show contracts with its dominant position and large consumer base. However, the company is overbidding for much of its content due to a variety of reasons. Firstly, Netflix have been lambasted in the past for not providing new, fresh content and also not providing enough content. This has caused it to broaden its range, however, at the same time this has increased the cost its paying on average for TV shows, which will undoubtedly have repercussions in the future. Secondly, Netflix is making some baffling purchases which nobody else wants, and paying through the teeth for these shows. This will further increase their costs, and shows that management still make some poor decisions if generally moving in the right direction. Lastly, and perhaps most importantly, Netflix and Amazon are starting to fight over exclusive content, which will drive prices up over the long run. Consequently, even though Netflix appears to be winning this pricing war, it might be disastrous for their profit margins.
Will The International Market Become Viable?
Netflix is making an operating loss internationally, there is no other way to cut the cake. Although it has aggressively advertised in the international market, it has yet to see the heavy subscriber growth that it so desperately needs. Due to many significant differences between the international and domestic markets (language being one notable one), I believe that the company will continue to struggle in its attempts to capture significant international interest. At the very least, Netflix will have to roll out a large-scale expansion in its non-English content before it becomes viable outside North America. Therefore, I expect continued losses, at the most meager profits, in the international market over the next five years.
Shares Are Very Overvalued, Driven By Speculation Rather Than Value
The consensus earnings estimates for 2013 comes to $1.30 per share. Therefore, for the market to be valuing Netflix correctly, over the next five years, earnings would have to grow at a geometric average of 25%, then Netflix would have to grow at a constant long term growth rate of 8%. All of this, along with a low discount rate of 10%, leads to an intrinsic value of $262.6 a share, still a full 18.6%, off its current share price ~$322.5, and 25.7% off the price of $353.2 I started shorting the stock at.
In a best case scenario, we can expect earnings for Netflix to grow at 20% over the next 5 years, and then maintain a long term growth rate of 7%, with a discount rate of 10%. This gives us a fair value of $142.3, 55.9% off the current share price. In a worst case scenario, I used a 5-year earnings growth rate of 12%, a long run growth rate of 4%, and a discount rate of 12%. This gives us a fair value of $42.6. Therefore, I believe, with a high degree of certainty, that the firm's intrinsic value lies between $142.3 and $42.6 a share, 55.9% and 86.8% below the current price respectively.
Personally, I calculated the intrinsic value of Netflix using a five-year earnings growth rate of 17.5%, a long term growth rate of 6%, and a discount rate of 10%. Therefore, I believe the company's intrinsic value is $97.6 a share, 69.7% down from the current share price. I plan on unloading 10% of my position for every 6.97% the stock decreases, I have consequently already unloaded 10%, and hold 90% of the short sell position I previously held. I am very confident about the intrinsic value of Netflix, and I see very little upside to the stock from current levels. Consequently, the risk/reward is very compelling, and is the reason I own a fairly substantial short position. Thanks for reading!