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Summary

  • Netflix is overvalued using all traditional valuation metrics.
  • Netflix has minimal pricing power, as seen in both its recent and 2011 price change.
  • Competition is starting to heat up, which will cause costs to rise.

While Netflix (NASDAQ:NFLX) is profitable, and provides a great service to its subscribers, it has a long way to go before its earnings can justify its current valuation. The closing price on May 14 was $351.88, which gives it a market cap of $21.09 billion.

High Valuation

Netflix's forward P/E is 50 compared to the market average of 16. Even if you factor in their growth rate and use their five-year PEG ratio instead, Netflix clocks in at 2.18, more than double their fair value. Back in October of last year, CEO Reed Hastings warned investors that Netflix's tremendous stock appreciation in 2013 stemmed in part from overzealousness by momentum investors. I've attached a chart of these various valuation measures and a few others you can use as well:

Click to enlarge image.

Source: Yahoo Finance.

Netflix also has a history of immense volatility. For example, in 2003 when Netflix reached a high of $55, it did a 2-for-1 split and then plummeted down to $11. In 2011, Netflix once again breached $300, only to fall back down around $60, a 74% fall. So a rapid movement downward would not be unusual, based on past stock performance.

It is also important to note that we are entering into the bull market's sixth year, and we already see signs of fatigue. Momentum stocks, such as Netflix, have especially taken a beating. The market has moved mostly sideways in 2014, but a catalyst -- such as an escalation in the Ukraine situation -- could push the market downward. A stock like Netflix would be disproportionally punished.

Netflix the Business

While Netflix the stock has its fair share of problems, one of the most troubling factors regarding Netflix the business is their lack of pricing power. Their poorly executed 2011 price change has left a black mark on the company. Netflix raised the combined price of their DVD plus streaming business by 60% back in 2011, and then proceeded to try to spin off their DVD business (they ended up not spinning off the business due to customer backlash). This yielded disastrous results and Netflix actually lost subscribers for the first time, causing their stock to plummet as mentioned above.

This experience led the management at Netflix to be overly cautious, robbing the company of some of its pricing power. Recently, management announced that they would be increasing the price from $7.99 a month to $8.99 a month for new streaming subscribers. However, while the plan is good for Netflix subscribers (I am one), it isn't good for investors. The plan is extremely generous, only raising prices 12.5% and keeping the cost for existing subscribers at $7.99 for two years, which has to be due to the debacle in 2011. Such a small price increase combined with grandfathering means that this will most likely not move Netflix's bottom line, as content costs are rising fast due to Amazon (NASDAQ:AMZN) also bidding for content.

Netflix also faces increasing competition from the aforementioned Amazon. They are also another reason that Netflix has so little pricing power. Amazon Prime (which gives Amazon customers access to Amazon Instant Video) costs $99 a year compared to Netflix's $108 a year, and comes with two-day shipping as well. Amazon is an Internet giant and posses greater financial resources than Netflix, which puts them in a better position even while they charge less. Netflix has $1.67 billion in cash and $900 million in debt compared to Amazon's $8.67 billion in cash and $3.15 billion in debt. Netflix's key advantage is their almost singular focus on streaming, but Amazon is starting to get serious about becoming a competitor to Netflix. They are bidding up content and also securing a deal to stream older, but popular, HBO shows (such as "The Sopranos").

Another problem mentioned above is that the FCC seems to have given up on pushing for net neutrality, allowing companies to pay ISPs for faster service. This means Netflix will have to spend extra money for that purpose in the coming years, and this could really become a problem if the merger between Comcast (NASDAQ:CMCSA) and Time Warner Cable (NYSE:TWC) occurs. That would give the ISPs greater negotiating power and allow them to charge Netflix even more for faster service. Netflix has criticized the merger as well, stating in their first-quarter shareholder letter that "Comcast is already dominant enough to be able to capture unprecedented fees from transit providers and services such as Netflix. The combined company would possess even more anti-competitive leverage to charge arbitrary interconnection tolls for access to their customers. For this reason, Netflix opposes this merger..." This has possibly put them on the bad side of these ISP companies as well.

Conclusion

Netflix's rapid growth is likely to keep the company profitable, while its modest price change is likely to keep its subscribers happy, but its bottom line is likely to be hurt by competition, rising content acquisition costs, and buying access to the new Internet fast lane. Shorting Netflix is risky, as shorting based on valuation can lead to substantial losses -- as seen with companies such as Amazon, Facebook (NASDAQ:FB), and Salesforce (NYSE:CRM). However, valuation is only meaningless during very bullish markets and, as mentioned previously, the bull market is showing signs of fatigue. Additionally, momentum stocks like Netflix tend to be heavily punished if they even slightly miss on metrics such as user growth, revenue, EPS, etc. If you do short Netflix, I would recommend buying puts with expiration dates in 2015 or 2016. This way your loss is limited to 100% (when shorting stocks traditionally, your loss is theoretically limitless).

Source: Netflix - Good Company, Bad Stock

Additional disclosure: I may buy puts on Netflix in the near future.