Netflix Is Facing Too Many Headwinds To Justify Its Current Valuation

Jan.20.14 | About: Netflix, Inc. (NFLX)

Netflix Inc. (NASDAQ:NFLX) provides internet television services to subscribers. These consist of movies, TV shows, etc. They can be displayed on TVs, computers, and mobile devices in the US and internationally. It offers domestic streaming, international streaming, and domestic DVD delivery. It is thought of as the pioneer in its space; but it has more recently been facing a lot of large and tough competition. For a company that trades at a PE of 276.18 and an FPE of 82.30, new, strong competition is a big concern. A "growth/momentum" stock needs only to show flat results for a little while before the market destroys its inflated price.

Let me mention some relevant facts. According to the US Census American Community Survey (2007-2011) there were 114,761,359 total households in the US. As of Q3 2013 Netflix had 31.09 million US members (or about 27% of the possible market in the US). Netflix expects to add 2.01 million net US subscribers in Q4 2013. This will bring the US penetration rate to almost 29%. At some point Netflix will achieve its maximum penetration in the US. At an earlier point it will find that new net adds are too costly to be profitable. It is hard to say when exactly this point will be; but Netflix is already seeing signs of slowing growth. The midpoint of its Q4 2013 guidance (+2.01 million) is already below the net additions seen in Q4 2012 (+2.05 million). Netflix could exceed guidance, but it likely will not be by much if it happens at all. If the net adds are flat to down year over year, then the revenue growth percentage for the US (or Domestic) market is shrinking. 2.01 million/33.10 million (+6.07% in Q4 2013) is a smaller percentage than 2.05 million/27.14 million (+7.55% in Q4 2012). This is a terrible trend for a company that trades at an almost astronomical PE multiple. Further increased competition and increased penetration is only likely to lead to further decreases in percentage revenue growth. These factors also seem likely to lead to an increased churn rate. This in turn will lead to decreased profits. NFLX does not supply churn rate figures.

The US/Domestic segment of Netflix is its only profitable segment. The international segment has yet to come close to being profitable. In Q3 2013 it had a contribution margin of -40.6%. When I queried Neflix's IR department about when the international segment would become profitable, they did not provide an answer. Over 10% of international members are unpaid members. Further the Q4 2013 net additions guidance is 1.31 million net additions. This is far less than the 1.81 million net additions in Q4 2012. This kind of slowing in revenue growth in the international segment is anathema to a "growth/momentum" company. It also makes profitability in that segment that much further away (if it ever becomes profitable).

Jim Cramer is always harping about revenue growth as a reason for recommending "growth/momentum" stocks. Yet even he may have trouble using this to support Netflix's too large PE. In the last three quarters NFLX has seen "total revenues" (both domestic and international) of $1,024 million (Q1 2013), $1,069 million (Q2 2013), and $1,106 million (Q3 2013). In other words, revenues have grown sequentially by +4.39% and +3.46% in the last two sequential quarters. This is slowing growth. The year over year net adds also showed slowing revenue growth for Q4 2013 versus Q4 2012 (using the midpoint revenue guidance number for Q4 2013). I don't see anything good here; and only a propagandist would.

When you look at the increasing amount of competition, you have to worry even more. From both a macroeconomic and a microeconomic standpoint it seems impossible that the growing competition will not adversely effect NFLX's profits. The number of households in the US is growing little if at all. NFLX is achieving higher and higher market penetration in the US (albeit more slowly recently). How can other companies offering similar services not detract from NFLX's growth and profitability in the US?

Some of the other companies are:

  • Amazon's Prime service (NASDAQ:AMZN)
  • HBO Go, a subsidiary of Time Warner Inc. (NYSE:TWX)
  • Time Warner Cable Inc. (TWC)
  • Hulu Plus -- a joint venture of several big media companies.
  • Google TV and You Tube (NASDAQ:GOOG) with increasing investment in original content.
  • Apple TV (NASDAQ:AAPL)
  • Comcast (NASDAQ:CMCSA)
  • Microsoft (NASDAQ:MSFT)
  • Sony (NYSE:SNE)
  • Dish Network Corp. (NASDAQ:DISH)

I am sure I have left out some; and I am sure some people will argue that I should not have included some. Many of these companies are just starting to compete with NFLX; but all are large companies. All are expected to provide an increasing amount of competition for NFLX. This seems sure to lead to decreased revenue growth, if not actual decreased revenues, for NFLX. For example Hulu Plus announced on April 30, 2013 that its subscriber base had doubled year over year to four million subscribers. Many of these subscribers will not want to also buy NFLX. Subtract roughly four million from NFLX's possible US customers. However, Hulu Plus subscribers pale in comparison to Amazon Prime subscribers. Amazon announced December 26, 2013 that Prime subscribers had topped 20 million. If you subtract roughly 20 million Prime subscribers (and growing) from the roughly 115 million US households, the number of potential NFLX customers has decreased by roughly 17%. If you add in the Hulu Plus customers, the potential NFLX subscriber base has decreased by roughly 21%. NFLX only recently claimed to have more subscribers than HBO, so HBO probably represents another 25%+ of possible subscriptions. That brings the total from just those three to about 46% of possible US subscriptions; and that is if every household in the US subscribes. My guess is that 20% or so will not subscribe to any premium service. That brings the total to about 66% of possible subscribers. Further all of the sundry other media providers, especially video on demand providers, have to account for a significant number of households.

If NFLX already has 33.10 million subscribers (Q4 2013 guidance) in the US, that represents about 29% of the potential market. That means that only about 5% of potential subscribers are currently not spoken for. Yes, NFLX can grab customers from other US premium content providers; but it will be more expensive. On top of that both Hulu and Amazon Prime seem to be growing faster than NFLX. To me that means that they are more likely to grab market share.

NFLX appears to be a dead duck. Yes, some people will subscribe to two premium services. A few may subscribe to all premium services; but these last will be very few. NFLX will find growth in the US harder and harder to come by in the future. In fact Morgan Stanley (NYSE:MS) recently downgraded NFLX to a $310 price target due to expected increased competition from Amazon Prime in 2014. Morgan Stanley analyst, Scott Devitt, says the competition, especially Amazon Prime Instant, Hulu Plus, and HBO Go, could take away NFLX's ability to grow its subscriber base in 2014. These words are pure poison to a "growth/momentum" stock; and from the numbers I have produced above, they seem inevitably true.

If all of the above wasn't enough, the US Appeals Court struck down the FCC's "net neutrality" rules (Reuters January 14, 2014). The FCC is considering an appeal; but it may get nowhere on that. Essentially it would be expecting the court to rule against free enterprise. What the destruction of the rule may mean is that ISPs may start charging for the amount of traffic. This would mean that either NFLX itself or NFLX's customers would have to pay more for NFLX content delivery over the internet. This would be a huge negative for NFLX profits. It would give internet service providers like Comcast a huge advantage in their offerings versus NFLX's offerings. Comcast wouldn't have to charge itself extra for the high amount of internet content it transmitted for its premium customers. This news wasn't out at the time of the Morgan Stanley downgrade. Therefore one might expect that the outlook for NFLX is worse than Morgan Stanley indicated at that time. Certainly the numbers for US subscriptions I came up with above indicate a very negative outlook; and NFLX is not close to profitability in its international business.

Further NFLX has seen 45% insider selling in the last six months; and it has seen 44.64% institutional selling in the prior quarter to the latest quarter. It has 13.10% short interest as a percentage of the Float. NFLX is a SELL. Aggressive traders may want to short it.

The five year chart of NFLX provides some technical direction for this trade.

Click to enlarge

The slow stochastic sub chart shows that NFLX is currently oversold. The main chart shows that NFLX has fallen steeply from its recent closing high of $380.58/share on December 23, 2013. The closing price on January 17, 2014 was $330.04. NFLX could see a technical rally after this; but the long term outlook is very bleak.

NFLX crashed in 2011, when its momentum waned. Then it rallied again to even higher heights, when its self-promotion by Reed Hastings et al turned market psychology in its favor again. Unfortunately for NFLX investors, there does not seem to be any real possibility of that happening again in the US markets; and Amazon seems more capable and established than NFLX in international markets.

NFLX is a SELL for investors. For aggressive traders it is a long term short. I don't pretend to know for sure how the stock will perform after its Q4 2013 report. Often stocks with high short interest can get short squeezed upward on even mildly positive news. However, the overall US subscriber picture for NFLX is decidedly negative. The numbers I cited are not imaginary. NFLX is a dead duck; and investors need to get out of it before it tanks to 10%-20% of its current value (as it has done in the recent past). My long term price target is $100/share or less within two years.

NOTE: Some of the above fundamental financial information is from Yahoo Finance.

Good Luck Trading.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in NFLX, over the next 72 hours. 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.