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Last October, corresponding with Carl Icahn's decision to sell 50% of his Netflix (NASDAQ:NFLX) holdings, a statement of the relevant underlying investment thesis along with Carl Icahn's response was released on 22 October.

I immediately picked up on multiple flaws in the thesis and took to Twitter; however, I decided to hold off on my full rebuttal until I built my short position and could make a reasonable projection for full year 2014.

In the below article- I will both dissect the flawed Icahn thesis and present my bearish thesis. I believe a 'fair price' for NFLX is anywhere from $87 to $130 (1-1.5X forward sales), with a midpoint/target near $110.

Historical Coverage

In the interest of full disclosure, I have been an on-and-off NFLX bear since 2010. I was a heavy short throughout 2011, and did very well for myself into the fall. In hindsight, I was clearly over bearish in February 2012 when I projected a 'major recapitalization or bankruptcy in 2013.' Long story short- I had the expenses figured close and correctly called the debt deal, but I missed average subs by a longshot (19.5M domestic and 2.5M intl versus actual 23.5M and 3.5M). This miss was huge considering the subscriber difference accounts for over $400M in annual cash flow!

I published my last bearish article on NFLX on January 30, 2013. In this article, I predicted an average (2013 yearly) of 27.5M domestic, 6.5M international paid subs, and 6.5M DVD. Through Q3-13, the actual average was 28.8M domestic, 7.1M intl, and 7.4M DVD; once again a substantial miss on my part. Once again, I continued to underestimate the speed of subscriber traction in the US. This potential error bias should be applied to my estimates for 2014.

Base Case/Assumptions

I will submit a base case cash flow model in the following days, with the assumptions of an average of 34M domestic (U.S.) subscribers at an $8 blended rate (assumes slight uptake of more expensive plans is offset by slightly larger uptake of cheaper plans) and 11.5M international subscribers at an $8 blended rate (offsetting exchange rate changes). Although DVD is clearly declining, I will model 6.5M at an $11 blended rate (actual was close to 7.5M @ $10.50 in the first 3 quarters of 2013).

Revenue-wise, I am not really in the 'bear' category- I am predicting $5.23B for FY14 versus average analyst estimates of $5.21B. However, analysts are expecting $4.02 EPS, or roughly $250M in profits assuming just over 62M shares outstanding. I believe Netflix will barely surpass 'breakeven levels' during 2014 due to accelerating content and development expenses.

The Icahn Thesis

Although linked above for those who want to read word for word, key statements by David Schechter and Brett Icahn (Carl's son), of which I believe every quoted statement to be flawed, include:

"Netflix's predominately fixed content cost gives the business model massive operational leverage."

"Reed Hasting's estimated range for a total domestic market size of 60 million to 90 million domestic subscribers implies that Netflix will add 30 million new domestic subscribers"

"At just $7.99 per month, we think Netflix has pricing power…"

"…increased spending on cost of revenues (largely content) by $1B annually [is a] 55% increase…"

"…the international opportunity is even larger in the long term."

"…we believe Netflix's valuation is still relatively low."

Interestingly, Carl Icahn's comments are short and sweet and amount to "a total return of 457% in only 14 months [means] it is time to take some chips off the table."

This return is phenomenal. Kudos to Carl Icahn for pulling the trigger in 2012 and having the wisdom to take massive profits (52.8% stake closed at average price of $323). The momentum play was exceptional. Bears, including myself, drastically underestimated the amount of subscriber growth that would occur in the US.

However, all that matters today is the decision of whether or not to invest in NFLX at a price of over $340 ($20B+ market cap). I believe anyone following at these levels based on the Icahn thesis (Brett's thesis- published in October at a price of $323) will be badly burnt in 2014 as the market readjusts and the pendulum once again swings the other way. If sane multiples return to the market and the NFLX expenses (and underlying structure) are fully recognized and discussed, the 2013-2014 y/y performance might make 2010-2011 look like a picnic for bulls.

(click to enlarge)

5-year chart- taken from Google Finance - note the massive drop in fall 2011 followed by a stagnant 2012.

First-Tier of Flaws: Leverage of the 'Business Model'

The first misconception, which sets the stage for all of the other flaws, is that Netflix is in possession, or has developed, an exceptional business model, which not only is difficult to duplicate, but has fixed expenses and lends itself to strong pricing power and operational leverage. None of this is true. Netflix has a strong brand name. Blockbuster, Borders, and Kodak did also. Netflix's user interface and content recognition could easily be duplicated by a competitor willing to spend just 5% of NFLX's market cap ($1B). Remember that NFLX catapulted its user prediction results by offering a $1M programming prize.

However, the primary investment point is the operating leverage potential. Does NFLX have 'fixed' costs for the foreseeable future? Only if you consider short-term contracts (1-2 years in many cases), you ignore all other confidential information including potential scalars (based on subscriber access) and multipliers (due to external events such as box office receipts), and you "conveniently forget" the fiasco that happened in 2010-2011 when Sony (NYSE:SNE) and Disney (NYSE:DIS) pulled movies from NFLX due to a breach of contract (due to higher than expected/contracted subscriber counts/access).

The truth is that NFLX's content liabilities have skyrocketed over the past several years, often at a far greater pace than streaming revenues are growing. This is the opposite effect than the "operating leverage" cited in the Icahn thesis. Additionally, most of NFLX's contracts are based on a minimal required payment, while the subscribers pay month-to-month. So, to reiterate, if the subscribers increase, NFLX might pay additional fees, but if subscribers decrease, NFLX still pays the same guaranteed rate. Doesn't sound like very strong leverage.

I fully suggest that everyone read page 14 of the latest 10-Q (Q3-13 quarterly report), prior to spreading any nonsense about "fixed" content costs.

Over the past 7 quarters (Q4-11 is the first quarter that breaks out revenues by explicit segment), 1-year total liabilities (measured as the minimal amount due with 1 year-included on each 10-Q-page 14 for Q3-13) have grown at a similar pace to streaming revenues. While Q4-12 represented a strong (bullish) growth in revenues versus liabilities, the trend has reverted for the past two quarters.

Clearly, revenues must grow at a faster pace than liabilities if NFLX desires to become profitable. The Icahn thesis suggests that the liabilities are nearly flat, while the facts clearly show strong growth (32.4% in the last year alone!).

(click to enlarge)

Second-Tier: Market Size and Pricing Abilities

While I do not disagree with Reed Hastings' assumption of a total market size of 60M to 90M in the US, I believe the Icahn thesis is extremely bullish when they assume NFLX will grow to 60M memberships within the next 4-5 years. Assuming the mid-point of Hastings' projections (75M), a 60M target assumes an 80% penetration.

I cannot think of a single market that has over 80% penetration by a single player. The premium movie/program channel market in the US is also large (over 90M), but the top players, Encore, HBO (NYSE:TWX), and Starz (NASDAQ:STRZA), have approximately 35M, 30M, and 21M subscribers.

With the exception of original programming such as the House of Cards and Orange is the New Black, NFLX is offering a commodity product. They have no distinct advantage over Amazon (NASDAQ:AMZN) or Hulu except for one thing-the size of their content library, as NFLX has consistently outspent its rivals. With Amazon beginning to push its Prime service, with ads first airing over the last two weeks, the gloves may finally be coming off. If a massive player such as Google (NASDAQ:GOOG), Apple (NASDAQ:AAPL), or Microsoft (NASDAQ:MSFT) enters the space, all bets will be off. Netflix would be squeezed out of the space and go bankrupt inside of two years, if a competitor like Google forced up the content bids.

There is a big reason why Amazon (who is known to champion growth over profits) is the only big-name competitor: there just isn't any sustainable profit to be made by serving as a content streaming middleman.

All of the true leverage is found in the content developers such as AMC (NASDAQ:AMCX), Disney, Lions Gate (NYSE:LGF), and Viacom (NASDAQ:VIAB) and the monopoly infrastructure providers such as Comcast (NASDAQ:CMCSA), Time Warner, Verizon (NYSE:VZ), and Cox. Netflix management understands this and this is why they are desperately trying to develop independent programming.

This both reiterates the fact that NFLX has no competitive advantage and has no real pricing abilities. With AMZN beginning to offer a similar service that costs approximately $3.25-$6.60/month ($79 for a 1-year subscription/$39 for college students), NFLX has no wiggle room to boost prices. With Amazon now advertising the prime video, I doubt it will be long until they offer a monthly subscription to video only-probably in the realm of $5-$6/month.

Netflix has just over $1.1B in cash, but Amazon has access to $7.7B and more potential to tap the capital markets ($20B vs. $180B market caps). If AMZN really wanted to secure the space, they could spend $5B or so on additional content, sell the service for under $8/month, and wait 2-3 years for NFLX to fall apart.

Netflix included the below chart in its Q4-12 results (Jan 23rd 2013), which illustrates NFLX's commanding lead in content. However, as many people have noted, this chart is highly flawed since it is described in terms of NFLX's content. If the chart was reversed, for example, to reflect AMZN's top 200, it's likely Netflix would also be much smaller. A key example is Amazon's exclusive run of the hit summer TV series, The Dome, within 4 days after live broadcast. Netflix still does not offer The Dome.

Interestingly, this chart disappeared from all subsequent earnings reports. In fact, not including the legal disclaimer for "Forward-Looking Statements," the keywords "compete, competition, Amazon, Hulu, Redbox, Google, and Verizon" were not mentioned once in the latest report. However, "HBO" was mentioned twice.

Third-Tier: Misunderstanding of Expenses and Growth Costs

This misconception ties back into the first-level 'operational leverage' discussion. Many analysts are under the impression that NFLX's content costs are fixed for multiple years to come, and the only key variable is revenue. This is untrue. Additionally, there are some key misconceptions surrounding the total cost of content. Referencing page 14 of the latest 10-Q, gives us the minimum expected content payments secured over the next 5+ years. (click to enlarge)Note the $2.77B figure due in "less than one year" and the $2.83B due "after one year and through 3 years." Common sense suggests that the majority of the "2-3" category is either likely bunched into the 2nd year and/or reflects bare minimums. Using $2.77B as a guide, NFLX has minimum content expenditures of nearly $692M (averaged) over each of the next 4 quarters. This compares to $522M from a year previous (Q3-12 report), reflecting a y/y growth of 32.4% in minimum commitments.

(click to enlarge)

Furthermore, as stated the $522M is a minimum. Actual following content expenses (domestic and international combined) over the first nine months of 2013 (Q1-13, Q2-13, and Q3-13 combined) were $1.91B, 22% higher than the expected $1.57B (522M*3). In full year 2012, the starting 1y liabilities (2011 report) were $1.71B and ultimately swelled by 18.7% to $2.03B (in 2012 report).

The largest/scariest factor here for NFLX bulls is that the growth in content costs actually accelerated from 2012 to 2013. The entire argument for the "virtuous" operating model is predicated on the reverse phenomena.

Assuming the mid-point of growth (approx. 20%), NFLX's quarterly "cost of streaming" expenses will be close to $830M (on average) for each of the next 4 quarters. This is on top of recent quarterly averages (which will likely increase) for marketing (approx. $122M), G&A ($45M), tech/dev ($94M), and other expenses including interest ($7M). Additionally DVD expenses run close to $119M per quarter (likely to decline to $110/qtr in 2014).

Thus, NFLX will require revenues of $4.94B over the next 4 quarters (Q4-13 thru Q3-14) just to breakeven, assuming a 10% growth in the non-content categories (11.7% growth last year). It should be noted that I expect $5.23B in revenues in 2014, which would lead to pretax profits of $290M (approx. $189M post-tax / $3.04 EPS); however, the $5.13B is for Q1--Q4-14 and the $4.5B breakeven is for Q4-13-Q3-14. I will wait to submit my full 2014 model until after I see the subscriber #s for Q4-13, but at the moment it appears my revenue projections are in-line with the market and perhaps even slightly bullish on the precise counts.

It should also be noted that approximately $860M of the 2014 revenues will likely come from the dying (but highly profitable) DVD-unit. Most analysts prefer to model only the streaming revenues and expenses, which in this case will likely be close to $4.3B and $4.5B respectively. Thus, DVD will continue to 'subsidize' the streaming operation despite management and analysts suggesting otherwise.

Last point, perhaps semantics, but Icahn (son) suggests a $1B boost to content expense represents a 55% boost to outlays. Based on the recent 3 quarters of "cost of revenues" adjusted to an annual figure ($2.55B), a $1B boost is only a 39% addition to content-compared to the 1y minimum liabilities (chart above from the 10-Q), a $1B boost is only a 36% addition. Clearly, someone either hasn't been reading the 10-Qs, cannot do math, or is operating under some unknown assumptions.

Fourth-Tier: Overestimation of International Potential

The international growth story has placed additional multiples onto the Netflix trading price. However, since the first major original announcements (mid-2011), NFLX has failed to deliver in terms of profit.

The Latin America expansion has proven to be problematic due to poor payment methods, rampant piracy, and poor internet infrastructure. Meanwhile, the UK and the rest of the European sector remains strongly competitive with Amazon's purchase and expansion of Lovefilm and recent plans for Japanese giant Rakuten to expand across Europe in the next two years.

In the long run, I am doubtful that Netflix Europe and Latin America will ever reach sustainable profitability. While Netflix Canada may 'succeed' comparatively, its numbers are small (2.5M-estimated to be a 25% English-market penetration), and competition is also heating up there. I see Netflix international as a costly boondoggle rather than as a source of profitable growth.

Fifth-Tier: Valuation Levels

This facet should go without saying Netflix is valued at extremely optimistic levels for any technology firm. However, based upon the previous dissection of Netflix's business model, the multiples reach atmospheric heights. Against expected (industry-wide analyst expectations-not my own) 2014 revenues of $5.21B and EPS of $4.02, Netflix is trading at forward multiples of nearly 4x sales and 85x earnings. These are high levels for any company, let alone one running at over a 40% market penetration (assuming midpoint of Hastings' 75M domestic streaming subs), with an unproven (profit-wise) international program, with extraordinary industry headwinds, and a non-virtuous (leverage potential) operating model.

To suggest that Netflix's valuation is "relatively low" is a gross misconstruction of the facts and industry-wide projections.

Summary

Netflix is extremely overvalued, but this is well known. However, the massive underlying content cost growth has not been adequately covered/discussed by either the mainstream news sources or 'top-tier' analysts. Public investments and endorsements by big names such as Carl Icahn and Goldman Sachs have further clouded the picture as Netflix soared to meteoric performance during 2013. I expect a massive correction in 2014 as the market wakes up to the financial realities of this 'growth' play.

(click to enlarge)

Trading/Investment Recommendations

Netflix is a scary beast to short. I faced massive losses in 2011 before the rewarding crash, and I was forced to cover my spring 2013 short during the summer. I do not recommend a direct short of NFLX stock (without a protective call as 'insurance'). I prefer to buy long-dated far otm options to avoid overpaying in premiums and to give adequate time for the market to adjust. I am currently long Jan 15 $170 options, and I like the pricing of the $200 puts (approx. $10). I also recently opened some 24 Jan (weekly- post earnings) $290 puts (approx. 15% out of the money). The latter is a pure trade/bet and I do not suggest such aggressive plays for my readers/followers.

It is my opinion that if NFLX falls below $200, it will fall below $100 shortly thereafter. I believe a 'fair price' for NFLX is anywhere from $87 to $130 (1-1.5X forward sales), with a midpoint/target near $110. I personally wouldn't pay anything over $65 (.75x forward sales / 16x forward EPS) for Netflix due to their precarious positioning, commodity product offering (i.e. razor thin profit margin expectations), and gigantic content liabilities.

Source: Sell Netflix: The Icahn Thesis Is Flawed

Additional disclosure: I am long AAPL, MSFT, and DIS. I am short Netflix via $170 puts expiring Jan 2015 and $290 puts expiring on January 24th (Q4-13 earnings play).