Most my readers and followers know that I am a fundamentally and long-term focused investor, rather than speculator, manipulator, or gambler. As an investor, naturally I am heavily poised to take long positions in stocks and rarely take short positions partly because I am more enthusiastic to see companies succeed than fail and partly because most shorting ideas are more short-term oriented due to the nature of shorting. Occasionally, I do see situations when a stock has been hyped to an unthinkably inflated level and the assumptions that need to stand and events that need to unfold in order to future revenue and earnings to grow at the rates needed to support the lofty price level are dauntingly unattainable in statistical sense that shorting of the stock is at least an intriguing idea to me. One such example right now is Netflix (NASDAQ:NFLX).
To begin with, Netflix already ranks at the bottom of industry list from my top-down selection. First, it is in a traditional, low tech business. Yes, not only its DVD service is old dog, but I consider even the streaming business is not any hot or new technology now. Secondly, the industry does not have any resource constraints or regulatory license requirements (unlike coal and oil industries LLEN and LPH are in). These two key characteristics of the industry mean that barrier to entry is low and competitors and imitators can get into the business and eat Neflix’ market share IF THEY ARE DETERMINED TO. Finally, it selling discretionary, leisure products, of which the sales are volatile and are usually cut relentless by consumers at economic down turn or when their pockets are tight (like right now when inflation eats into their income). Statistics show that just these three characteristics along almost ensure that a company’s ability to sustain above average revenue or profit growth rate (especially on the profit side because companies can expand revenue with the sacrifice of profit or even at a loss). As such, a company with these characteristics should be placed at a valuation multiple lower than those of other companies with similar short-term profit margins and growth rates. The valuation level and price trend of Netflix stock from 2006 to 2008 were generally in line with this principal. However, starting from the beginning of 2009 the stock suddenly roared out of gate and has kept on gravity-defying rise for about 2.5 years under the continuous gang blockbuster, herd flocking pumping by the CEO and whole bunch of hedge funds and bankers, sending the stock to a rightly money-robbing level of almost 80 times TTM EPS and 60 times FTM EPS basing on average first call analyst estimate (http://finance.yahoo.com/q/ae?s=NFLX+Analyst+Estimates), which is at the high end of the estimate of $4.20 to $4.50 from my statistical quant model.
Backing up this super long stretch of jaw-dropping price inflation were a series of actually not so jaw-dropping compounded annual revenue growth rate of only 26% from 2008 to 2010 and 33% from 2008 to 2011 (basing on average estimate of $3.27 billion revenue for 2011). In comparison, LLEN grew its revenue by 55% annually from fiscal year 2008 to 2010, LPH grew its revenue also by about 55% annually from fiscal year 2008 to 2010. Ok, ok, I know they are Chinese companies and small caps, but how about Apple? Even Apple grew its revenue by 42% annually from 2008 to 2008 and 49% annually from 2008 to 2011(basing on average estimate of $107.90 billion revenue for 2011). Why should I give Apple, a company with much more technology sophistications, a premium brand image that is untouchable by its competitors, and as a result much more solid advantages and secured revenue and profit growth rates, at only 16 times TTM earning while paying multi-fold price for a Netflix stock at 80 times TTM earning? I cannot think any reason from asset valuation stand point to give Netflix such a fat bonus in pricing.
Now, most investors, including the CEO and those hedge funds and promoters of the stock, would agree that the stock definitely should not deserve such a valuation basing on the revenue and earning trends over the past 3 years. So, what other selling points have they put in their marketing campaign to successfully fooled investors into giving them such a high price for each share of stock? A dream of worry-free growth for years to come mostly, a dream that is largely unrealistic and unlikely to come true.
Many investors, especially retail inventors, have amazingly short memory and forget lessons learned quickly. No stocks, especially stocks in traditional business (DVD rental certainly is, and in my view even streaming is not a hot new tech stuff anymore either), can defy gravity and shoot to the moon. People forgot what happened to Blockbuster, Hollywood Video, Movie Gallery (MOVI), and AOL. Like Netflix, Blockbuster and AOL, two names no less dominating and powerful in their respective businesses in 1990s than Netflix is today, fought hard to thwart off a demise of stagnating and thinking businesses replaced by similar, but improved, products or ways of service delivery. Let’s not forget how strikingly similar the situation of Blockbuster’s in 1990’s was to the situation Netflix is facing today. Blockbuster was a super Wall-street darling for a decade before start seeing real market erosion to new form or movie delivery by Netflix, pretty much like Netflix is facing competition from yet a newer form of movie delivery – streaming video – today. The CEO and most his “pumper alliances” – some hedge funds, I-Banks, and manipulators (including a notorious CNBC entertainer who told all viewers of his show: “Bear Stearn is fine! Do not sell the stock” two days before the collapse of the stock) kept on dismissing the power of Netflix’ competition even when the signs of Blockbuster’s revenue and profit growth slow-down manifests in the first couple quarterly reports (pretty much like Netflix’s last quarterly report). After a couple years of late into the game (pretty much like Netflix is to streaming video today), Blockbuster finally started adopting into the new form of business to try to transfer its revenue from old business to new business. Not surprisingly, the CEO told the public that the company would be able to dual with the product offerings from its major competitors including Netflix and Redbox and use its brand name to be the market leader in the new form of business. Sounds to me similar to what I have been heard repetitively from Reed Hasting and some analysts that that Netflix can trump online streaming offerings by all other competitors – Redbox, Hulu, Amazon, Walmart, Lovefilm, Youtube, Blockbuster, Zediva, cable service providers (e.g. Time Warner Cable), etc. Well, guess what? It’s the 100+ year old economics and statistics doctrine, not the CEO’s and hyping analysts’ optimisms, that stood at the end: Blockbuster did experienced major problems replacing all its revenue from then existing business model to a new business model and did lost quite an huge chunk of market to new competitors.
A more alarming, and maybe more similar comparison to Netflix from the aspects of logic-defying revenue/income growth and stock inflation, is MOVI. Like Netflix, MOVI was hyped to the core by hedge funds and speculators from cents to almost $40 a share when the company kept on beating analysts’ estimates for several years amid abundant skeptisms and warnings from several whistle-blowing fundamental focused analysts and the CEO kept on selling the fantasy growth story that the company could keep on multiplying even when it was forced to go out of its comfort zone and tread into an unfamiliar (and proven lethal) territory (see http://seekingalpha.com/article/315-movie-gallery-movi-meets-consensus-revenues-increase-15-in-quarter, http://seekingalpha.com/article/189-movie-gallery-movi-hits-consensus-blames-same-store-sales-decline-on-the-calendar-the-box-office-and-the-weather) until all of sudden all kinds of problems including revenue and earning shortfalls foretold by several insightful analysts sprouted altogether in a swift. After the first pull back from $37+, the truths of the company’s ugly margin squeeze and revenue contraction (a reversal from eye-popping growth like Netflix has been dishing out for several years) were quickly discovered, sending the stock to an almost free-fall to single digits within a couple months (http://www.businessweek.com/magazine/content/06_19/b3983073.htm, http://en.wikipedia.org/wiki/Movie_Gallery).
Even if Netflix CEO is indeed so superior in leading a company in a slow-growing industry to fight all competitions and cost pressures, I don't think he is a super man and don't think the stock can be worth even $200, a price level for a forward P/E of no less than 40. As one of the most famous sentences from Warren Buffett says: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Now, I am not saying that there is a 90+% chance that Netflix will certainly lost most of its business in the next couple years. However, to believe and promote the opposite – that there is a 90+% chance that Neflix will thwart off almost all competitions, not experience any problems in revenue transformation and margin pressures, only be affected minimally by equally or even more technologically advanced rivals, and keep on enjoying 30+% YOY top line and bottom line growth every quarter going forward – criteria that need to be met in order to even marginally justify the stock at current valuation level – is an unconscionable and completely irresponsible thing for me to do as an analyst. Of course, there have been a lot of talks about international expansions – Canada, Europe, Latin America, etc., but really, how successful the company can be in competing in Europe, a place where people heavily favor local brands and American products are not particularly successful and where most people are struggling to even make ends meet at heavy debt crisis right now? Will Latin Americans be willing to pay high enough even to pay for Neflix costs in these countries? Canada? Forget about it. It is a country with combined buying power roughly half of California. It will not save Neflix in any way. China or India in the future? Ah I won’t count on those either. People there don’t pay for copyrighted materials. In fact, Netflix should thank god that most American consumers haven’t realized that they can watch a lot of movies free on Youku.com, Sohu.com, and many other web portals in China (many people from China living in the U.S. do and thus never use Netflix).
As said I think the company will deliver full year EPS of $4.20 - $4.52, below or match current analysts’ consensus EPS estimate of 4.52 in the best case scenario with noticeable revenue/earning miss against existing street forecasts for Q3 and Q4 (sure these forecasts are likely to be slashed by some first call analysts in the next a couple weeks). For 2012, currently probability weighted mean EPS is somewhere $4.20 to $5.00 by my calculation, meaning that YOY earning growth will be single digit if the company only experiences moderate slowdown in its growth and possibly negative if domestic subscriber attrition deteriorates. At current a price of $272, the stock is trading at 55 - 65 times two-year out earning. Under universal methodologies and principals for valuing assets and earning streams, I cannot see why I as an investor should buy an asset that give me less than 2% return on invested capital (inverse of the P/E of 50), with returns growing at only single digit, and facing all kinds of downfall risks. From purely intrinsic valuation stand point I would only pay $100 top for the company’s $4.52 EPS this year and low growth rate going forward. Understanding that in stock market an overly hyped stock can take some time to re-align to its intrinsic fair value, I’d say $150 - $180 might be a reasonable equilibrium price for the stock to adjust to by the end of the year.
Another telling sign that has been sneaking under most investors’ attention radar is the staggeringly lopsided insider sells versus buys over the past 12 months: http://www.nasdaq.com/asp/holdings.asp?symbol=NFLX&selected=NFLX&FormType=form4
Sure, insiders can sell occasionally for need of cash rather than being bearish on the business outlook, but unloading 7 million shares (about 14% of shares outstanding) in 12 months and 1.66 million shares (over 3% of all shares outstanding) in 3 months while only buying only tiny 52K shares in 3 months is never a kind of normal, measured selling. Even if most of the sells are conducted under pre-arranged automatic periodic option exercising and simultaneous stock sales, the pace of the program as a whole is still a rush sale and a vote of pessimism on future stock movement in the minds of the management team and board of directors. If the outlook of the company is really so bright as some analysts have been painting and the stock should be able to be justified at higher prices within a year, while don’t the management team and board of directors accumulate more shares or at least slow down selling of their shares? The answer: because they know likely pretty soon the game of “I am buying the stuff regardless of how ridiculous the price is as long as I can sell to the next fool willing to pay even higher prices”, the game that so many irresponsible people played in housing bubble, will be over.
I am a completely independent analyst and am not paid by any company of which the stock I cover or write articles about. However, I may have long or short position on a stock I cover or write about at any time.
My ratings and/or analyses of a stock only represent my personal view on the stock and/or my assessment on the probable movement of the stock price in the next 12 months. They are by no means a guarantee of performance on any long or short trades on a stock and should not be relied upon solely for buying or selling a stock. Every investment, no matter how compellingly appealing it seems, involves risk. Investors should do their own due diligence and consider personal risk tolerance, preferences and needs when making an investment or a trading decision. All materials are subject to change without notice. Information is obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed.