Can't Fight The Law Of Large Numbers - Nix Netflix Now

| About: Netflix, Inc. (NFLX)


Netflix pays no dividend, so it has no income component to hold the stock price up.

NFLX had 5.59 million net subscriber additions in Q4 2015; but it had only 1.56 million net additions in the US. This was down from 1.90 million in Q4 2014.

Reed Hastings did not say the above was an anomaly that would be remedied soon. Instead he cited the Law of Large Numbers with respect to US adds.

Only US operations are currently profitable.

Netflix Inc. (NASDAQ:NFLX) is an Internet television and movie network. It delivers TV shows and movies to computers, tablets, phones, and other devices within the US and internationally. It has three segments: domestic streaming, international streaming, and domestic DVD.

Netflix has been a cult, momentum stock. A lot of people like the service. Therefore they like the stock; and they like to keep pushing the stock upward. Like many momentum stocks, it is a highly shorted stock with 13.47% of the Float shorted as of December 31, 2015. Momentum stocks typically rise to inordinate heights due to momentum and HFT trader short squeezes on any sort of good news. However, such valuations can have big downsides as NFLX has already shown in its history. For example, from July 3, 2011 to November 21, 2011 NFLX stock fell from $42.16 per share to $9.12 per share. I note the prices above are split adjusted prices. NFLX lost more than -78% of its value over a six month period. There are more examples in NFLX's history too.

The above example is what happens to a momentum stock when its growth starts to lag, or its starts to be outperformed by one or more other companies. When Reed Hastings cited the Law of Large Numbers, he effectively told the markets that growth in the US has run into a strong headwind. I am not sure Reed Hastings used the Law of Large Numbers term exactly correctly. However, NFLX is definitely running into a numbers headwind in the US. The Q4 2015 net US subscriber additions were only +1.56 million compared to Q4 2014's +1.90 million. Reed Hastings did not call this an anomaly. He effectively said it would be a continuing headwind.

In 2014 there were approximately 123.2 million households in the US according to the US Census Bureau. There were 43.40 million total US paid NFLX memberships in Q4 2015 (44.74 million if you include non-paid memberships). In 2013 only 74.4% of households reported Internet use. This means there are approximately 91.66 million available households with Internet available. More recently I have been hearing a 97 million figure, but I have no substantiating source for that. In either case NFLX is getting close to supplying 50% of the available households in the US with service, although a few households may have more than one subscription. When you consider that many households will not even want a streaming service, NFLX may already be supplying over 50% of the available households in the US. In other words, it will likely see a continuing downturn in the number of net US subscription adds per quarter. The churn rate will increase. The most interested customers have almost all already signed up. Plus the remaining supply of potential customers (potential new subscription additions) in the US is dwindling with each increase in the total number of US subscribers.

When you see virtually all of NFLX's fiscal metrics worsening, you have to know there is trouble ahead for NFLX's stock price. Q4 2015 NFLX metrics include:

  • Net Income of $43 million -- down from $83 million a year earlier.
  • EPS of $0.10 per share -- down from $0.19 per share a year earlier.
  • Free Cash Flow of -$276 million -- down from -$78 million a year earlier.
  • Streaming Content Obligations of $10.9B -- up from $9.5B a year earlier.
  • International Streaming Contribution to Profit of -$109 million -- down from -$79 million a year earlier.

Yes, the number of net international subscription additions appears to be accelerating (4.04 million in Q4 2015 compared to 2.43 million in Q4 2014). However, that part of the business is not yet profitable; and most do not expect it to become profitable for several years into the future (if at all). Meanwhile the US business is becoming less and less profitable. That means slowing profits for NFLX, especially as the US churn rate becomes higher. It is easy to see how NFLX's current EPS could become negative by Q4 2016. You could argue that NFLX is still expanding quickly by growing revenues and subscribers. However, all subscribers are not equal; and all foreign countries seem to demand more work to make the business work. That should mean thinner profit margins, if those foreign subscriptions do eventually become profitable.

Canada, Australia, the EU, and perhaps India (a former British colony) are the only areas that would seem to be able to easily adapt to NFLX. South Korea might like NFLX. However, putting in subtitles for a small country is an expensive proposition (again thinner profit margins). For China, there are many dialects. Portuguese applies only to Portugal and Brazil.

I should be making my point. I watch Korean shows on Hulu sometimes. I know I wouldn't watch them if there weren't subtitles. I don't speak Korean. NFLX has a PE of 354 and an FPE of 91; but I don't see it actually achieving its 91 FPE. Plus that is high for a company at which growth is slowing in its one profitable area -- the US. Remember also that the churn rate will likely go up soon. It will be more expensive to try to retain the marginal subscribers (subscribers who are less addicted or attracted to Netflix). Plus the competition from Amazon (NASDAQ:AMZN), Hulu, etc. is increasing.

Investors should look at the competition. Amazon is a relative newcomer to the streaming business. Yet Prime already had 44 million subscribers as of June 2014. Amazon added 3 million new Prime subscribers in the third week of December 2015 alone; and that virtually ensures that AMZN added over 10 million new subscribers for Q4 2015. Comparatively NFLX added only 5.59 million new subscribers; and only 1.56 million of those were in the US. It appears that AMZN is growing faster than NFLX. There are many other competitors such as Hulu too. Research company MTM estimates that NFLX's market share will decline from 85% in 2014 to 50% in 2018. A lot of competition is coming, even if NFLX appears to be the first big player on the international scene. More competition is bound to mean higher churn rates and lower profit margins.

On top of that NFLX just announced that it was raising monthly subscription rates on its formerly grandfathered in customers in Q2 and Q3 in 2016. To get the HD plan, they will now have to pay $9.99 per month. NFLX will probably lose a small number of customers this way.

The switch to chipped credit cards has also been hurting NFLX. Many credit card customers have to change their numbers as they switch to chipped cards. This gives them an added opportunity to opt out of NFLX. That is, if they have to fill in new information to continue their Netflix subscription, they may at that time decide not to continue their subscription. Again this will probably only be a small percentage of subscribers; but each small percentage adds up. There could also be those that simple don't update their information. Their cards would then become invalid. Netflix would have to spend more to get them to update with the correct information. Some would likely choose not to continue. Some might even have forgotten they had a subscription. Those might take that opportunity to end their subscription.

Netflix has also been losing its media contracts. Most recently it failed to sign a new deal with Epix. NFLX management felt that a "non-exclusive" contract with Epix did not justify the cost. Instead it will try to produce more of its own content. It plans to launch over 600 hours of original programming in 2016. This will be up from 450 hours in 2015. However, this strategy is fraught with peril too. Many of the shows it has produced to date have been very successful (House of Cards as an example). The problem is that if you produce more shows, you tend a bit more toward mediocrity. Each idea cannot be "the best". Each show cannot have "the perfect cast". Further as NFLX derives more and more of its revenues from these shows, the actors, directors, writers, etc. will demand more and more money over time.

The above strategy may be a decent one. Original content may be more attractive and/or more sticky. However, cost will still ultimately be a problem. NFLX may only succeed in pushing the cost problem out a few years (if that). The then added costs may turn out to be just in time to destroy the profitability that some analysts are expecting once the startup infrastructure and new employee costs of its international business are mostly behind it.

In sum NFLX should see near term problems with profitability. It should see slowing growth in its "profitable" business -- US Streaming. It should see added costs for such things as adding subtitles and/or adding different language versions of a show for its international streaming business. It still has a problem with growing content costs. It has the problem of maintaining the high level of success it has so far seen in its original programming content. With a larger amount of new content planned, NFLX seems destined to see mediocrity in at least some shows. That will impact the way the company is viewed; and it will impact profitability.

NFLX is overpriced at the moment. Its own CEO Reed Hastings acknowledges that US streaming growth is slowing. This trend cannot likely be reversed due as Reed Hastings said to the Law of Large Numbers. Carl Icahn has sold his stake in NFLX. NFLX is a SELL. It may be a great SHORT for the next year or more. Perhaps it will look better if and when the International Streaming business starts to turn a profit (or at least gets much closer to doing so). Investors should wait on the sidelines for if and when that happens. On top of the above, the US and world economies have been looking more troubled lately. The US stock market is overdue for a BEAR market. Dump NFLX for at least the next year. You will be glad you did. It is not going anywhere quickly; and the overall market may be going down considerably. NFLX with a Beta of 1.44 seems sure to follow it.

The two year chart of NFLX provides some technical direction for this trade/investment.

Click to enlarge

The chart above shows severe weakening. It appears to be a double top formation. That is one of the most negative chart formations possible. It appears that the stock price is currently near a major support point. After Reed Hastings comments about the "Law of Large Numbers" applying to US subscription growth, there is strong fundamental reason to believe that NFLX will break through this support line. After that it could easily fall to the $65-$70 per share level. That is where the next strong technical support level is. At that point, investors could re-evaluate a short position (if they open one). However, NFLX looks like a STRONG SELL/SHORT at this time.

NOTE: Some of the fundamental fiscal information above is from Yahoo Finance.

Good Luck Trading/Investing.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in NFLX over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.