Netflix, Alibaba And Stock Manipulation

| About: Netflix, Inc. (NFLX)

Summary

The factors behind the recovery in NFLX are ephemeral and misunderstood.

Maturing content obligations have forced management's hand at exactly the wrong time.

The necessary results for the coming year look unattainable, and leave little downside even if they are somehow achieved.

Netflix (NASDAQ:NFLX) stock has recovered most, but not quite all, of the losses it experienced in conjunction with what should have been a catastrophic earnings report three weeks ago.

NFLX 1mo chart

This article will examine the reasons for the recovery, and of course, update the near and long-term outlooks.

BS Buys

The first event that has helped the rebound is a $51.9M insider buy from Director Jay Hoag at an average price of $86.50. Like all insider transactions, this is a legitimate positive, but this particular instance is riddle with caveats:

  1. This is the only insider purchase in over a year. Every other of the 60 transactions over the past year was a sale. This is an apples to oranges comparison. Nonetheless, it is worth noting that true insiders have sold over twice the number of shares, and CEO Reed Hastings has sold over twice the dollar amount over that time.
  2. Hoag is not a simple Netflix employee; he is co-founder of Technology Crossover Ventures, which is heavily invested in Netflix. Thus, those who think this is a large purchase for him are simply misguided. $60M could easily be a small fraction of Hoag's bonus, and I suspect that will be the unofficial, private actuality as compensation for making this move.
  3. Having lots of capital doesn't necessarily mean smart investing, though. TCV has raised $12.36b, including $2.6b this year, yet appears to have $7.5b in assets under management. Hoag was #22 on the Forbes Midas List in 2012, after NFLX made its first run, but dropped to #62 in 2013, and fell off entirely in 2014.
  4. Similarly, Hoag did nothing but sell NFLX in 2015 and all in the earlier part of the year, before the stock hit its most dramatic highs.

To me, it's clear that Hoag's most recent purchase was not so much a statement of long-term faith in Netflix as it was a defensive transaction motivated by TCV to mitigate the more than half billion dollars in options transactions that would occur if the stock price did move.

The more recent bump up was for another 4% on Friday, from a rumor that Alibaba (NYSE:BABA) was reportedly formulating a bid for Netflix. The follow-up, which of course was published after the close of trading, was this article, titled "Alibaba Denies Reports Of Interest In Netflix."

Personally, I used the latter bump to rebuild my short position on the stock, after having taken some 180% in annualized profits immediately after earnings. To my mind, the proposition that Netflix will be acquired, by anyone, is more or less completely ruled out by its valuation, which compares unfavorably even to other high fliers on just about any metric one would care to look at. That said, I would never short a stock on valuation alone, so here's some more detail on my thinking...

Debt and Catalysts

I think it has become pretty clear that Netflix has overpaid for content. One example of this is House of Cards, where the company reportedly paid $100M for the 26 episodes in the first two seasons and even more for subsequent seasons. By contrast, NCIS costs about $2.5 per episode. Those costs are coming home to the balance sheet. According to the latest financial report, the company is now up to $13.2b in content obligations. Of these, $5.5b are due in less than one year, and $6.3b in 1-3 years. The company has $11.6b of assets on the balance sheet, but cash and equivalents have dwindled to less than $1.4b. About a quarter of the assets are classified as current content and half as non-current content assets. Over the past year, the negative cash flow for Netflix has ballooned to a consistent loss of over 50 cents per share each and every quarter, for a decrease of $878.8M in the past year. This, in combination with the asset liabilities, is why Netflix has to raise prices now.

Yet, as discussed in my prior article, management's own comments indicate to me that, for many users, current content isn't compelling enough to even justify current prices, let alone higher ones. The defection rate for Netflix was already at 9% back in April. I don't really need to know exactly how subscription numbers will progress in order to be fairly certain that the bar is too high.

Netflix had $7.6b in sales over the last four quarters and is now at 82.4M paying subscribers. Even if everybody's prices were going up 25% to $10 and subscriptions remained steady, that would make for ~$2b in extra revenue, and $1b in profit. These numbers are wildly optimistic for the sake of simplicity. Only an estimated 22M subscribers were at $8, and they have the probably have the option to downgrade to their original plan to maintain that price. Those who joined after May 2014 are already at $9.

That leaves subscriber additions to fill the gap. The next earnings report is due in mid-October, and Netflix forecasts adding 2.3M streaming subs. It would need to beat that number by the extra third analysts were originally looking for and maintain that pace in order to just catch up with its near-term content obligations. I very much doubt that Netflix can pull that off in the face of the external headwinds being added to its own content quality problems:

Beyond the fall, I see another capital raise in the cards, and given the balance sheet, the terms are likely to be ugly.

Risk Factors and Conclusion

All short positions require careful and experienced risk management. The factors behind the recent rebound in stock price are ephemeral, but I will not be surprised to see more attempts to negate the danger of a long squeeze over the final two weeks before the August options expiration. For instance, I had suspected that a share buyback might be announced. The trick here is that such announcements are merely authorizations, with no obligation to actually deplete the balance sheet further. The only problem with such a move would be that the strategic problems would be directly attributable to management, unlike the discredited buyout rumor. These are merely short term dangers, but they could easily be of consequence to an over-extended position. That alone could have aided what may ultimately amount to a dead-cat bounce.

When I first wrote about the stock it was very much an open question whether or not Netflix was overpaying for content. The intervening 3 years have made it increasingly clear that the cost of a first-mover advantage is not translating into a sustainable business model for the company. Even if I am wrong about near-term events and growth prospects for the company, merely managing to avoid balance sheet rescue would still leave Netflix extremely over-valued. NFLX would then amount to an almost ideal market hedge. With markets at all time highs, and numerous macro-economic dangers, I see plenty of asymmetry as well as opportunity here.

Disclosure: I am/we are short NFLX.

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.