Netflix: The Netscape Navigator Of 2014

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 |  About: Netflix, Inc. (NFLX), Includes: AAPL, AMZN, GOOG, MSFT
by: Sujan Lahiri

Remember Netscape Navigator? Most of you probably remember Netscape's web browser dominance in the 1990s. But it lost most of that share during the first browser war. The usage share of Netscape had fallen from over 90 percent in the mid-1990s to almost nothing a couple of years later. Shares of Netscape followed the same path. Shareholders were spared a complete loss of investment when AOL took over the company in 1999. I believe history tends to repeat itself and think a similar case is unfolding now with Netflix (NASDAQ:NFLX) as its shares are extremely overvalued. I bought some out-of-the-money put options on the open market and argue these will pay off big time.

Bubble history

Bubbles come and go. Everybody knows that, but why do bubbles occur in the first place? A stock rises from a rational to a more irrational level, moving away from its fundamental value into greater fool territory. Most investors hail the product the company is commercializing as the "only choice" and "soon to take over the world by storm". That might be true in the short term, but sooner or later common sense kicks in. A monopoly in a free market won't last long, as competitors, which probably did not exist before, step in. Hey these competitors might even produce a better product! And sell them at lower prices? History proves this is almost always the case. You better not hold a long position when that happens. Wall Street seems to greatly underestimate the chance a company is to lose its near monopoly position, and thus its large market share in a free market. Look at Tesla (NASDAQ:TSLA), did you really think competitors won't step in and try to outflank Tesla on both product and price? Investors woke up, smelled the coffee and the stock cratered by a third. So let's see how Netflix holds up in this story.

Mediocre product

I recently checked out the product. I don't live in the U.S., but was able to see the U.S. version. To be honest, I wasn't impressed with the content. All movies are rated b-category, and there is no recent top movie available. The series are all right though and so is the documentary section. The monthly $8 fee appears reasonable, but, given the content, not a bargain either. The streaming quality is not top notch. I searched online for other opinions and read that critics, by and large, aren't impressed as well. It's not bad, but not truly unique either [unlike the first products from Apple (NASDAQ:AAPL) for instance]. It does become bad when you check out the non-U.S. versions. I gave the Dutch one a try, and was shocked about the really poor content (just 1/10th compared to U.S.). 8 euros on a monthly basis is then a rip-off in my opinion. Critics online flame the "international version" and advocate that non-U.S. citizens could access the U.S. content by applying some browser tricks.

So overall, the product is mediocre at best. To put in other words, there must be other companies out there that do a better job.

A Full Blown VOD War Is Impending

In defense of Netflix, that is not really the case yet. There are some other streaming services available (HBO, Hulu, Lovefilm, etc), but none of them can be considered a full-fledged rival. Statistics show however Netflix's market share is slowly eroding. And experts indicate that the competition is about to get much fiercer. Microsoft (NASDAQ:MSFT) (Xbox One), Apple (Apple TV), Google (NASDAQ:GOOG) (YouTube), Amazon (NASDAQ:AMZN) (Amazon Prime) and Comcast are all on the doorstep. Akin to the first browser war, I believe a VOD war is about to break out.

Therefore I believe the growth story is behind us and market share erosion will accelerate. The problem Netflix has is that it isn't able to significantly expand its content without a price increase. But any price increase would cause more customers to cancel (price elasticity). Catch22. In the years to come, customers will even have more choice, and there is no stickiness to a subscription. Switching your entertainment supplier is as easy as switching your mobile phone subscription.

The Numbers Indicate Extreme Overvaluation

Let's look at some basic financials.

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Given that growth is slowing down and margins are decreasing these multiples sure indicate an extreme overvaluation.

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The balance sheet is not that great either. Shares ($350) are trading way over its book value and the high debt/equity ratio is alarming. Even more alarming are the billion dollar content obligations that are not even shown on the balance sheet. I wonder if most investors are aware of this.

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The cash flow statement shows Netflix is not able to generate cash on a structural basis.

Insiders are selling aggressively

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Insiders are only selling throughout this year. Not one time did they buy. A classic red flag. Interestingly, Reed Hastings, the CEO, put a warning out last month concerning the "euphoria" that surrounds his company's stock price. Investors should take notice.

Time to wake up and smell the coffee

Netflix could be the biggest bubble stock on the market now. The product is mediocre, and they are in a catch22 situation of not being able to improve content and technology without hurting profitability. I read about subscriber growth; sounds nice, but a large part are free-trial signups that yield no profit. I heard that promo trick before when all these internet providers IPO'd in the infamous dotcom era, boasting about their large subscriber base. Did they make money? You know the answer. Further, the balance sheet is not solid and cash flows are on and off positive and negative. As soon as the competition heats up, Netflix could take a serious hit. If insiders are selling aggressively for months now, I suggest you take the profit and run as well.

The trade

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The chart indicates the share price is topping and trading sideways for a few weeks now, providing a compelling entry point. If volatility is lower, put options become less expensive. I choose put options (January 2015), because the investment is much smaller than shorting the expensive shares, limiting the potential maximum loss, but maximizing the profit in case of a, in my view likely, sharp drop in share price.

So in conclusion, I think Netflix's extreme overvaluation presents a super interesting asymmetric risk/reward opportunity.

Disclosure: I am short NFLX. 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.