On Wednesday, March 9, I made a poorly timed trade to short Netflix (NFLX). Seeing that the stock was tumbling from its all time high of 247.55, which it reached on February 14, I thought there would still be some more downward momentum given the heavy negative sentiment on this stock. Unfortunately, I jumped on the momentum train a little too late. After losing money on the trade, I decided to reexamine my thesis to get a better picture of what I did wrong.
As Netflix’s stock price spectacularly soared in 2010, a number of bearish bloggers presented a convincing case that the company’s high stock price failed to discount some fundamental risks. Some of the fundamental concerns addressed include:
- A host of big-name competitors are stepping into the market and may threaten Netflix’s dominance as a provider of on-demand media. Some of these competitors include Amazon.com (AMZN), Coinstar (CSTR) (owner of Redbox), Hulu, Facebook, and cable operators.
- Netflix may lose favorable pricing with its big-studio media content suppliers when contracts are up for renewal.
- The quality of the company’s earnings is poor because of weak cash flow. The company deferred recognition of its content acquisition cost, hiding its true cost off the income statement as an asset on the balance sheet.
When the stock price began tumbling from its highs, I believed that Netflix’s stock valuation was in the process of a significant correction that would send its stock price back into the mid-100 range. Around December, traders betting against Netflix then decried its price around 180. Although they were proven wrong during the first two months of 2011 when the stock rallied, it seemed that the rally indeed stalled out at 247 and by the beginning of March, the tide turned in the short seller’s favor.
I went short on March 9 at a price of 192, a day after Facebook announced a deal with Warner Bros. to stream The Dark Knight. In an “aha!” moment for short sellers, NFLX gapped down under 200 as the headlines circulated that Facebook may be the newest long term competitor of the streaming media giant.
Unfortunately, my short sale did not turn out well as the next day a Bank of America sell side analyst released a statement that put the Facebook news in perspective. The report suggested that Netflix’s business is positioned differently from other players in the market because the content and method of delivery of Netflix does not directly compete with the other new entrants in the streaming media market. In order for a new player like Facebook or Amazon to compete, it would take significant investment to build the same content library as Netflix.
After the release of the analyst report, NFLX rallied. I decided to cut losses at 200 and cover my short. It was time to reevaluate how risky betting against this stock could be.
Priced for Perfection, or Long-Term Buying Opportunity?
After performing some more prudent research on the bearish thesis, I have come to the conclusion that the long term investors are likely to be right. Over the last year, Netflix quickly built itself into a household brand name for streaming media, and it will be difficult to dislodge that image. It found ways to conveniently integrate into entertainment appliances like the X-Box and Wii, which are already connected to millions of living room television sets across the country. Netflix users have easier access to watching video through a television than other competitors offer at this time.
As for the argument about its content negotiations, I am not concerned. How credible is the assertion that its suppliers will be so greedy that they will bite the hand that feeds? Good media libraries take time to build. As we have seen, the music industry faced a slow evolution of its delivery channels as the digital download market developed. The recording industry initially outright fought the online distribution of music (i.e. the Napster era). Then came iTunes. iTunes initially had a limited media library with many DRM restrictions. It was only recently that The Beatles' collection became available. Over time, the recording industry became more receptive to loosening its copyright restrictions and we can now download MP3s for $0.99 with no strings attached.
Like online music, Netflix itself has steadily improved its offerings and I anticipate they will only get better. Should the content suppliers begin charging more, I think Netflix could easily pass the costs onto its subscribers. As a Netflix user myself, it does seem that the infrastructure is in place for the company to set up a “premium” level subscription or pay-per-download types of service to access newer content.
Financial Numbers a Reason for Caution
I view the accounting treatment of Netflix’s content library as the most credible financial threat. I think there are two issues worth reviewing: the company’s management of its working capital, and a large off-balance sheet commitment to purchase new titles.
I do not think the working capital issue is unusual. According to the statement of cash flows, the company spent $406 million in cash in 2010 to build its streaming content library. Critics of Netflix’s financial reporting claim that this practice is shady because it takes the true acquisition cost of its library off the income statement and hides the cost as a balance sheet asset. However, I counter that argument with the fact that many businesses engage in similar accounting practices to smooth out earnings by recognizing such irregular costs over a stretch of time. On the Q4:10 conference call, management mentioned that last year the timing of the content purchases was unusual and that the cost is expected to reverse in Q1. Also, with about $350MM in cash and investments, I do not believe the company faces a cash crisis caused by its treatment of working capital at this time.
The off-balance sheet commitment is somewhat alarming. Some of the company’s financial commitments are not reported on the financial statement, but appear in the footnotes. According to the footnote found in the 10-K:
The company had $1,075.2 million and $114.8 million of commitments at December 31, 2010 and December 31, 2009, respectively, related to streaming content license agreements that do not meet content library recognition criteria.
What this effectively means is that the company has committed to almost a billion dollars in licensing commitments last year, and we do not know how soon Netflix will be expected to pay for these commitments. Because the pricing of these titles is unknown at present, these commitments could represent for Netflix many titles at a low cost, or a few titles at a high cost.
Because of the investment the company has made into building its library of content, it will need to continue strong subscriber growth to pay for such commitments. Any trip-up in gaining new subscribers could cause potential dips in the stock price around earnings season. Another problem caused by the off-balance sheet commitments is that the company may be slowly loading this liability onto the balance sheet, which over the long run could dampen earnings and cash flow even if subscriber growth remains strong. The off-balance sheet line item is something to watch for in the next 10-Q.
Trading Lesson Learned
The one important takeaway that I learned from trading against NFLX is that it is a bad idea to bet against the stock of a company that is generally well managed and has solid fundamentals on its side. While I identified the accounting treatment of the content library as a potential risk, I would consider Netflix’s financial standing far better than any implosive “dot-com” stocks, or subprime mortgage lender. At this time, Netflix does not seem to have a toxic balance sheet, and a fixation on technicalities is not enough to make a bet against the strong potential growth of the company.
Most professional money managers I’ve spoken with who invest in growth companies seem to not mind holding a company with a high valuation. They generally believe that if the long-term horizon is optimistic, it doesn’t matter if the stock trades at high multiples because earnings will be expected to catch up eventually. Long term investors hold on to stocks like Netflix because they see growth several years out, enough to overlook the near term risks of price depreciation in the stock.
What to do Now
As a long term investment, I am optimistic, but would only wait for a fire sale buying opportunity to get on board. Such a buying opportunity may arise. We still have macroeconomic problems which could in general bring down high-multiple stocks like Netflix.
Some short term directional stock calls may be too tough to call. At its current price, I see the path of Netflix stock at a crossroads that could go either way. The long term business prospects seem promising, but high valuation could easily cause new investors to lose significant money over the short term horizon. For the short sellers, the question is how much pain they are willing to take if the stock continues to march higher. It is unclear whether the short sellers may in fact be spelling out their own doom by supporting the stock price as they cover any meager gains. Over the next twelve months, both sides could be right. However, timing trades to be profitable may prove to be as dicey as making bets on a roulette wheel.
Perhaps the first step of figuring out how to play this stock is to realize that it’s not like surgery. While a doctor may be forced to make risky decisions in order to save a patient’s life, a stock trader is in a much more advantageous position. With stocks, the option to walk away and look for a chance to cash in on an opportunity elsewhere is always on the table. To quote the popular flick Wargames, "The only winning move is not to play."
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
