After a nearly 1100 percent increase in price since late 2008, continuous disbelief on the part of many investors who simply don't understand how the stock keeps gaining, and bigtime pain for those who took the risk of betting against it - it may now finally be the right time to short Netflix (NFLX).
From a low of $18 in late 2008 to a high of nearly $250 on February 14, 2011, Netflix is one of the top performing stocks of the past few years. It did, in fact, take over the DVD rental space - and sent the once-dominant Blockbuster chain into bankruptcy. It also sparked a wide interest in easier DVD rentals, with millions of subscribers paying a few dollars a month for the convenience of having movies shipped to their house. And now, it has ventured into the video streaming business as it tries to keep up with the rapidly evolving technology and consumer.
Yet while its stock price has soared in spite of the 33 percent short interest (investors betting against it) and the multitude of investors who couldn't find justification for such high valuations, there are a few important and daunting questions still to be answered. And these potential obstacles could turn into much bigger problems if they are able to derail the momentum Netflix (NFLX) has enjoyed thus far.
Clues to Potential Trouble Ahead:
1) Valuation. Based on valuation alone, Netflix is almost priced for perfection. With a P/E ratio of nearly 80, investors are expecting very high growth. With reasonable P/E levels at around 20, Netflix is highly regarded as a very promising company. But as many had learned all too well in the Dot-Com Bubble, exorbitantly high P/E ratios are usually not sustainable - and could lead to severe price corrections. If Netflix can't keep up with expectations, it has set itself up for plenty of trouble.
2) Transitioning Business Model and Competition. Though it started off and established its business as a DVD-rental company, Netflix now finds itself at a crossroads as it tries to dominate the streaming video business. Unlike DVD-rentals, however, where it had a significant advantage and near-monopoly on the industry - after essentially beating Blockbuster - Netflix now faces increasing competition for streaming content. Other companies, such as Amazon (AMZN), Apple (AAPL), Hulu, Google (GOOG), Disney (DIS), and Coinstar (CSTR) are all attempting to gain market share; and Netflix no longer has as much exclusive power as it did before. The streaming business model simply is not as dominant as DVD rentals.
As Whitney Tilson wrote in his article "Why We're Short Netflix":
In short, Netflix is moving from a business in which it was competing against smaller, dying, heavily-indebted companies with inferior business models to some of the largest, most powerful, aggressive and deep-pocketed companies in the world, which have big competitive advantages over Netflix.
3) Streaming Library is Weak. Because it offers such low-cost subcriptions of under $10 a month, Netflix doesn't necessarily have the resources to pay high fees for streaming content. With increasing costs for streaming content and the unfeasibility of providing customers with the newest releases, Netflix may also experience some pressure on margins as it has to pay increasingly more for its content. Not only may it end up having to pay more, but it may also end up with a weak streaming library with a largely incomplete selection. And if customers become dissatisfied with the lack of selection, the competition may be able to force itself into the market.
How weak is Netflix's streaming library?
Quoting Whitney Tilson again:
To come up with a representative list of popular movies, we took the top 50 grossing movies of all time, Internet Movie Database's 20 top-ranked movies of all time, Rotten Tomatoes's 20 top-ranked movies of all time, and the 10 top-selling, top-renting and top-video-on-demand DVDs for the week ending 11/28/10.
Here's the summary: of these 120 movies (including duplicates), Netflix has a mere 17 (14.2%, and 0% of the current most popular movies) vs. 77 for iTunes (64.2%), 63 for Vudu, 62 for Amazon, and 41 for cable.
This chart depicts the results graphically:
As you can see, Netflix may be regarded as a top video provider, but if we look at the data in this case it does not appear so.
4) CFO Resigns Unexpectedly. Barry McCarthy, who had been with the company since 1999 and led it through the IPO, resigned in December 2010. To the shock of many, and with the supposed claim that such a decision was made in order to "pursue broader executive opportunities outside the company," McCarthy's designation immediately sent off a warning alarm in my head. Such a vital company figure resigning amidst extreme upward momentum tells me something may be brewing behind the scenes or under the surface. And especially when such a figure was the CFO, who is largely in charge of monitoring the books and maintaining strong finances, such a resignation may be a sign of upcoming trouble.
5) Heavy Insider Selling. To make matters worse, CEO Reed Hastings and now ex-CFO Barry McCarthy had sold their shares time and time again - with McCarthy exercising 100,000 options at over $200 a share. Such heavy insider selling can signal the lack of faith in a continued stock price uptrend. In other words, if the leaders and executives of the company are pulling their money out of the company, why should the average investor (who has much less clarity into the company's operations) leave his money in? Heavy insider selling is many times a warning of an impending downturn or potential "shady" behavior. When I see a CEO and CFO selling out of their shares at very high prices, and the CFO resigns unexpectedly, I think it's time to be a little wary.
6) Whitney Tilson Gives Up. After garnering a lot of attention with his article about shorting Netflix, and after seeing big losses as the stock continued to rise in the face of his great arguments against it, Tilson decided it was time to admit defeat in fighting the tape (See "Why We Covered Our Netflix Short). His original arguments were supported with great data, and I agreed with many of his points. Furthermore, the fact that the Netflix CEO, Reed Hastings, wrote an article to refute Tilson, also sent me a warning signal; if Netflix was really that strong and growth was to continue as it had been thus far, would a CEO really bother putting himself on the line and writing an article to disprove the bears? But Tilson decided it wasn't worth the losses, as NFLX continued to rise regardless of its potential hurdles and extreme valuations.
My point in bringing up Tilson's decision to exit the trade is that such an act could signal that it's actually the right time to short NFLX now. And why would it be time to short now, after such an iconic Netflix bear finally capitulates on his bet? Because Tilson's decision to give up on his short could be a signal of a NFLX blow-off. What I mean by that is that sometimes the trade only moves your way when you've finally given up. In other words, Tilson shorted NFLX as it continued to rise, and decided to give up after some major financial pain - but the drop may come right as he gives up. It is not unlikely that many investors were betting on NFLX precisely for the reason that it was heavily shorted, by the likes of Tilson. Hoping to squeeze Tilson and others out of the trade, many investors were able to push the price of the stock up until some of the short sellers finally capitulated. But now, once one of the most well-known Netflix bears has given up, it may be time to short.
Again, I would also caution that a capitulation by the bears could actually cause a continued run-up in the stock price, as the overhead bearish resistance is removed. But I do think that, at least in the short-term, Tilson's capitulation could signal a good opportunity to sell.
7) Technicals. After seeing a tremendous rally backed by very high volume since August 2010, Netflix's meteoric rise may now be unsustainable. Though the technicals visible in price levels still don't point to a NFLX correction, the candlestick patterns do.
If you look at the two charts, you'll see that NFLX may have formed bearish reversal candles on both the 1-year daily chart and the 2-year weekly chart. On the 1-year daily we have a bearish harami (or inside-day), which signals the top at $247.55 - right near the big psychological $250 mark. On the 2-year weekly we have another potential reversal candle - the Doji - which signals much indecision on the part of investors, and a potential upcoming reversal.
If the next week is a negative one for NFLX, the $247.55 high we have just witnessed may stick for a while.
As we've seen, Netflix has been a revolutionary company which has changed how we watch movies and videos, and has continuously shocked investors as it rose time and time again in the face of high valuations and numerous doubters. But with competition closer than ever, higher upcoming streaming content costs, a very shady CFO resignation, high insider selling, and finally a capitulation by one of the big NFLX bears - it may now finally be time to short it.
The best ways to play this trade:
1) Sell NFLX short with a stop-loss at $250-255 if it continues to rise.
2) Buy NFLX puts (either the June or September 240-250 strikes could work).
3) Protect your NFLX longs with put options.