Netflix Is A House Of Cards On The Verge Of Collapse

Feb.24.14 | About: Netflix, Inc. (NFLX)

Netflix (NASDAQ:NFLX) is no longer a viable long-term investment due to the firm's extreme overvaluation and deteriorating fundamentals. However, the stock's strong momentum makes shorting it a very risky strategy. Instead, investors should place bets using put options which provide more leverage and have limited downside risk. Once the momentum turns negative, the selling will be heaviest in stocks like Netflix whose valuations make very little sense.

Netflix Cannot Afford to Keep Spending Billions on New Content

The key risk surrounding Netflix is the rising cost to acquire new content. This problem will only get worse over time as deep-pocketed competitors like Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOG), Apple (NASDAQ:AAPL) and others continue bidding up content prices. In FY13 alone, Netflix spent over $3 billion on content acquisitions (nearly 90% of total streaming revenue). As its high-margin DVD business continues to decline, it will cause further deterioration in Netflix's free cash flow… forcing the firm to take on additional debt to help fund operations.

Figure 1: Free Cash Flow vs. Net Income

Source: Blitzkrieg Capital, Company Reports

As can clearly be seen in Figure 1 above, there has been a significant deterioration of free cash flow since FY11. But what is even more interesting is that Netflix's net income has remained relatively stable during this time. In other words, the earnings quality (difference between net income and free cash flow) is getting worse. However, I believe there is a simple explanation for this. In a rapidly growing business such as Netflix, amortization (affects net income) will always lag cash outlays (affects free cash flow), allowing the firm to look more profitable in the short term than it actually is.

Figure 2: Amortization Expense Lagging Actual Cash Outlays

Source: Blitzkrieg Capital, Company Reports

Sadly, net income is just an accounting number and cannot be used to pay the bills. This is why Netflix now has to raise $400 million of new debt in 1Q14 in order to have enough cash to continue buying expensive content. Following this new debt raise, Netflix will have $900 million in long-term debt. The company also has $3.1 billion of content liabilities on the balance sheet, and an additional $4.1 billion of off-balance sheet content liabilities. In total, long-term debt + content liabilities will now exceed $8 billion. It is important to mention that any content obligations with variable-term agreements (e.g. unknown price or number of titles to be received) are not included in the total content liabilities figure, however, these "unknown content liabilities" are likely in the billions as well.

Figure 3: Long-Term Debt + Content Liabilities

Source: Blitzkrieg Capital, Company Reports

As Netflix's free cash flow continues to deteriorate, the firm will most likely be forced to raise additional debt going forward. At this rate, Netflix will eventually dig itself into a debt-hole that it cannot climb out of. Bankruptcy is a definite possibility within a few years if this continues.

Subscriber Growth Will Peak Sooner Than Most Expect

The total number of U.S. households is estimated to be roughly 122.5 million in 2013. I think it is fair to assume that this is Netflix's total addressable market for its domestic streaming business. That means that Netflix already has 27% market share, based on 33.4 million domestic subscribers at the end of 4Q13.

Figure 4: Netflix's Domestic Market Share in 2013

Source: Blitzkrieg Capital, Company Reports, U.S. Census Bureau

Netflix's management estimates that they can capture up to 90 million domestic subscribers over the long term, or roughly 70% of the total addressable market. I believe this is overly optimistic for the following reasons:

  • Firstly, Netflix has been facing increasing competition in online streaming. Along with Amazon and Hulu, Blockbuster (NASDAQ:DISH) and Comcast (CMCSK) have also entered this space. Going forward, Verizon (NYSE:VZ) and Redbox (NASDAQ:OUTR) can post stiff competition as they have partnered to offer a competitive streaming service. The growing competition can not only put pressure on Netflix's subscriber growth, but also increase content costs due to bidding by competitors.
  • Secondly, in order for Netflix to avoid eventual bankruptcy, the firm will need to be free cash flow positive. The only way to accomplish this is by raising subscription prices and reducing the amount spent on content acquisitions. This means that subscribers will be forced to pay a higher monthly fee for less available content, both of which will have a negative effect on long-term subscriber growth.

Investors should not put too much faith in Netflix's international expansion either. The international streaming business is likely to remain a relatively lower value contributor for several years because Netflix will face high content costs as well as local competition and resistance. Moreover, markets such Latin America have lower broadband penetration and per capita income, thereby making any rapid growth in this region difficult for Netflix.

A Bubble About to Burst

Netflix has been one of the best performing stocks over the last couple of years. From the 2012 low up till now, Netflix shares have returned over 700%. Now at a market capitalization of $26 billion, Netflix is an extremely risky bet because it is based on a perpetually cash-hungry business with eternal obligations that will never be met. Eventually the market will come to its senses and price Netflix accordingly. Yet, this does not mean that the stock will not go to $500 or even $1000. Right now Netflix is a momentum stock… irrational speculators buy it because they believe that a "greater fool" will buy it at an even higher price than them. This is why Netflix has turned into a bubble stock, and like all bubbles, it will burst one day.

I would discourage investors from short-selling Netflix. During stock market bubbles, a lot of investors lose a tremendous amount of money prematurely shorting stocks based exclusively on valuation concerns. Netflix is a momentum stock in the midst of a very strong bull market, so the best way to play this is by using put options (limited downside risk and more leverage). Once the momentum in the market shifts to a more negative environment, high-flyers like Netflix are almost always the first to go. The selling is always the heaviest in stocks whose valuations make very little sense.

Bottom Line

Netflix is no longer a viable long-term investment due to the firm's extreme overvaluation and deteriorating fundamentals. However, the stock's strong momentum makes shorting it a very risky strategy. Instead, investors should place bets using put options which provide more leverage and have limited downside risk. Once the momentum turns negative, the selling will be heaviest in stocks like Netflix whose valuations make very little sense. Bet against this house of cards before it is too late!

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.

Additional disclosure: I am short NFLX via Puts. I may purchase additional puts over the next 72 hours.