Netflix and F5 Join the SPY - But Why?

Includes: FFIV, NFLX
by: Karl Denninger

There's dumb, and then there's desperation. As reported by Reuters: "Netflix Inc. (NASDAQ:NFLX), F5 Networks Inc. (NASDAQ:FFIV) and Newfield Exploration Co. (NYSE:NFX) will replace Office Depot Inc. (NYSE:ODP), The New York Times Co. (NYSE:NYT) and Eastman Kodak Co. (EK) in the S&P 500."

This is all good, right? Put the winning in the index.

Well ... maybe.

Netflix has a P/E of 72, and F5 has a P/E of 74. Only Newfield has a P/E somewhere near the index's underlying multiple, trading currently at 15.

Here's the problem, in a nutshell: Putting stocks like these in the index expands the multiple on the index itself and exposes it to large losses linked to the collapse of those multiples.

I find such moves appalling, even though in this particular case we're talking about two out of 500 stocks. Nonetheless, the lack of vision in the people constituting the index and making these decisions is a warning to those who are index followers or index investors, as these actions raise the risk materially.

You often hear in the press about "Risk On" or "Risk Off." What people tend to associate with "Risk On" is rising market prices. But in point of fact, both are reactionary; if you're buying the index as a consequence of rising prices, your buying in anticipation of future returns is based on something that already happened.

Those who follow me know that I'm very negative on Netflix in the intermediate and longer term, mostly because my analysis of its business model says that it's basically "poaching" other people's build-out costs. Everyone who finds a way to exploit someone else's paradigm in a way they didn't anticipate can "win" for a while, and extract a large amount of money, directing it to their pocket.

This, however, does not change the essence of what Netflix is doing: It's found an exploitable angle on someone else's investment, and that person is going to get upset and, with a high degree of reliability, expend a lot of effort to shut down the "poach."

Whether the carriers (last mile and otherwise) will succeed in this endeavor remains to be seen when it comes to Netflix. I believe they will, ultimately, although the timing remains problematic. There are a lot of people who share my view, in that there's a huge short interest in NFLX, some 20% of the float, which means that in the short term the potential for very ugly short squeezes is very high. Thus, attempting to act on and profit from what I believe is this "poach" is nerve-rattling and subject to large losses (or worse, forced buy-ins, which turn mark-to-market losses into realized ones) if you get the timing wrong.

F5 is even more amusing. Here's a company that has every characteristic of the high-fliers like UUNET, Winstar and PSINet from the 1990s, all of which ultimately wound up gone. The company currently trades at a price/sales of more than 12 and nearly 11 times "tangible" book ... but what is "tangible book" when some of it is comprised of plant? There's a problem hidden in here in that the market value of hardware in this space, compared to amortization schedules and acquisition costs, is always ridiculously out of whack. As someone who ran a company in this space, I can tell you with certainty that this is always true -- yet not one "analyst" will talk about that part of the puzzle.

Then you look at price to free cash flow and you find a ratio of nearly sixty.

Okay, we're in orbit on this one. Better hope it doesn't de-orbit right on your head.

Point being, neither of these firms are "industrials" and neither makes a tangible good. Both are high-flying momentum plays subject to monstrous reversals. If NFLX and FFIV were to be cut back to the index's P/E, they'd fall by more than 75% in price.

Mean-reversion is a bitch, and ultimately it has a nasty habit of happening at the worst possible time.

Dance here with your eyes wide open and one foot through the door.