Somewhere in California, Netflix (NASDAQ:NFLX) CEO Reed Hastings is probably laughing while lighting a Cuban cigar with an $100 bill while Dom Perignon flows freely out of all household faucets. (At least that's what I'd be doing if I was him.) Whether or not he's actually celebrating extravagantly, he certainly has earned the right to; after calling out short sellers with an open letter published on Seeking Alpha a few months ago, his company, Netflix (NFLX), just reported a quarter (see conference call transcript here) that propelled shares to new highs.
But the recent report revealed a hairline fracture that is developing in Neftlix's seemingly-impenetrable armor. Countless Netflix bears have argued that the switch from mailing to streaming content may lead to the demise of high-flying Netflix shares. One statistic, I believe, is very worrisome: the growing cost of purchasing content to stream.
Between Q1 and Q4 2010, the cost of purchasing streaming content grew by $124 million, from $50m in the first quarter to $174m in the recently-ended three months (these statistics are pulled from the "Content Library" line on the Statement of Cash Flows). During this same time period, revenue only grew by $102 million (from $494m to $596m). Profit has grown significantly over the same time frame due to other aspects of the business; Q1 profit was $32m while Q4 net income was $47, which has ultimately given Mr. Hastings and NFLX shareholders reason to celebrate.
Much of this profit growth, however, has been due to closely controlling expenses; from Q310 to Q410, marketing expense fell by $18.4m while net income increased by $9m. Obviously, it's a great thing when the business manages to grow as spectacularly as Netflix continues to do while cutting marketing costs, but at some point, cost cuts will begin to hurt the business. When the cost of doing business (buying content) is increasing faster than revenue, I don't know how shareholders couldn't be concerned; margin contraction is the type of thing that could halve NFLX's P/E and share price.
Another interesting figure was the Q4 income tax provision. At $27.464m, it essentially matched the Q3 provision despite $9m in additional income before income tax in Q4. The provision in Q4 was only 36.8% of income before income tax, compared to rates of 39-42% during Q1-Q3 and a 39.7% rate in 2009 and 39.9% rate in 2007. Netflix explained the lower-than-usual figure by stating in the letter to shareholders that "
Our effective tax rate (ETR) was lowered to 36.8% as a result of this [R&D tax credits included in December's new tax law] and the tax benefits from options exercises.
While Netflix provided a legitimate explanation for the decreased tax rate, it's still notable that Netflix had a ~$2m benefit to net income from the decreased rate, and interesting (or coincidental) that the company managed to forecast provisions well enough during Q1-Q3 that, despite changes from a law passed in December, full-year income tax provisions exactly matched the benchmark seen in 2009 and 2007.
An intangible sign of an eventual opportunity to profitably short is that euphoria is setting in. It's understandable that bulls may want to take a victory lap, but sentiment seems unreasonably rosy. I happened to watch a few minutes of Jim Cramer tonight and he argued that it's time to value Netflix by using whatever price-to-sales ratio Facebook, LinkedIn, or any other internet company is trading at, suggesting that Netflix shares will soon be fairly-valued at $400.
While I admit that his ability to detect, predict, manipulate, and profit off of market sentiment is infinitely greater than mine, I think it's simply ridiculous to argue that Netflix shares should trade at 20 or 30 times sales because some very different companies that happen to also utilize the internet in their businesses have such valuations.
I was not short Netflix anytime recently and am not short shares now, and I think that getting short tomorrow would result in a lot of near-term pain. But the unsustainable valuation coupled with real business uncertainty and challenges will likely mean that some bold short sellers with impeccable timing will make some big money off of Netflix sometime in the not-too-distant future.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.