Seeking Alpha

Maxsoar's  Instablog

Maxsoar
Send Message
MaxSoar Group is an investment analysis team. We research and analyze a broad spectrum of financial assets including stocks, bonds, mutual funds, real estate properties, and private companies. Our knowledge and connections are especially strong in mainland China, Hong Kong, Taiwan, U.S. west,... More
  • Netflix - 100 Year Old Wall Street Game of Blind Enthusiasm and Fooling of Retail Investors Continue 13 comments
    Jul 26, 2011 8:41 PM | about stocks: NFLX, GOOG, AMZN, AAPL, LLEN, LPIH, BIDU, SNOFF

    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.

     

    Disclaimer

    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.

Back To Maxsoar's Instablog HomePage »

Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.

Comments (13)
Track new comments
  • joey554
    , contributor
    Comments (605) | Send Message
     
    EXACTLY!!!!! Good article
    28 Jul 2011, 02:09 PM Reply Like
  • Onelessgod
    , contributor
    Comments (39) | Send Message
     
    Well done. I would love to hear your analysis of the Cash Flow Statement. The quality of earnings is very poor. Netflix is aggressively amortizing content expenses and manipulating CFO. Your thoughts?
    28 Jul 2011, 02:17 PM Reply Like
  • Maxsoar
    , contributor
    Comments (255) | Send Message
     
    Author’s reply » Onelessgod,

     

    Good question. Please see my feedback on my stock analysis site www.staranalystonline.com.

     

    Thanks.

     

    Kevin
    29 Jul 2011, 12:55 PM Reply Like
  • winchester_u
    , contributor
    Comments (50) | Send Message
     
    Excellent article.

     

    The best analysis that I've read for a long while.

     

    Analysts from GS, Citi, Piper J., etc. projected future growth and earnings of Netflix based on a model of no significant competition, and that the field will remain static for at least three years!!

     

    what about cap on broadband imposed by ATT and Verizon?

     

    What do you think is their motive ?
    28 Jul 2011, 02:22 PM Reply Like
  • winchester_u
    , contributor
    Comments (50) | Send Message
     
    Cramer, Ingrid Chung of GS, and other purported Analysts are shameless in the way they pumped this stock.

     

    They are creating a great speculative play that made some people rich,including insiders like Reed Hastings. They also directly caused a bubble in this stock which will make a lot of devastated bagholders in the near future.

     

    Sad.
    28 Jul 2011, 03:57 PM Reply Like
  • LyteSpeed
    , contributor
    Comments (28) | Send Message
     
    I can't believe all that is written here without mentioning the dire financial position of this company. This 15 billion market cap abomination has just 168 million in cash with over 500 million in A/P and more incredibly...their ridiculous OFF balance sheet obligations total over 2.4 billion.

     

    All of the analysis on competition, sizing up growth/international expansion, etc is meaningless here. The company's business model is an utter joke that has them in a HUGE financial hole that they will never even be close to paying off.

     

    Just another transfer of wealth from what's left of Main Street wealth to the Wall Street criminals.
    28 Jul 2011, 04:23 PM Reply Like
  • terrablank10
    , contributor
    Comments (65) | Send Message
     
    Hooray for your post LyteSpeed. You have the full grasp.
    29 Jul 2011, 06:43 AM Reply Like
  • Maxsoar
    , contributor
    Comments (255) | Send Message
     
    Author’s reply » LyteSpeed,

     

    Very good observations. I am surprised to see this comment of you now after I finished written my last article responding to Onelessgod's earlier post. Please see my feedback on my stock analysis site staranalystonline.com.

     

    Thanks.

     

    Kevin
    29 Jul 2011, 12:57 PM Reply Like
  • srast
    , contributor
    Comment (1) | Send Message
     
    Yes, the off balance sheet liabilities are particularly troubling. These liabilities exceed the on balance sheet total assets of the company. When this stock falls, it will fall like a rock. As an accountant, I beleeive fundamental analysis will always win out. I remember those who in 2007 said AMBAC and MBIA could not fail. I did quite well purchasing puts on both of these companies. I am going to do some more analysis this weekend and possibly pursue a put strategy.
    29 Jul 2011, 07:32 PM Reply Like
  • LyteSpeed
    , contributor
    Comments (28) | Send Message
     
    KC,

     

    Latest write up on NFLX at your blog covers some of the issues I have with this company. Nice to see you noted the potential issues with the USPS moving forward, a topic not covered that often. Also the question regarding how they count subs is of interest to me. I know Netflix customers can put their account on hold and there is no doubt Netflix includes these non paying subs along with all the free subs. As I posted elsewhere on SA the discrepancy between Nielsen's data, indicating roughly 8 million unique streamers every month, and NFLX's disclosure that 22 million subs have streaming capabilities has me intrigued. Sure not everyone who has the service will use it but 14 million gap is puzzling. Appears Nielsen's method for measuring users is faulty or Netflix is lying.

     

    Your insights on this type of business in general terms and its potential for profit is most telling. As mentioned there are literally no barriers to entry and there is unlikely to be a pot of gold waiting for companies with this type of business. If there was a ton of money to be made in streaming lots of garbage from the 90's Netflix wouldn't exist. Huge companies like Apple, Amazon, Google, Dish, etc would already be in the space. It is interesting to note recently that Amazon and the potential acquisition of Hulu has picked up steam, somewhat coinciding with Netflix's price hike.

     

    I will lastly say in this particular case management should be in no way be given the benefit of the doubt, not only in terms of accounting but in every aspect of their business. They have a history of class action suits against them for lying/deceit, suppose most notably the case involving "throttling".

     

    ----------------------...
    Judge Issues Final Settlement in Netflix “Throttling” Class Action Suit

     

    San Francisco - A federal judge has approved a settlement agreement in a class-action lawsuit brought by subscribers of online DVD rental service Netflix, that will award a free month of rentals to 5.5 million current and former subscribers, the Associated Press reported. Filed in 2004, the suit accused Netflix of misleading customers with regard to its delivery policies. The company was found to give preferential treatment to less frequent renters, as compared with those who quickly return their movies and thereby increase the company's costs — in a practice dubbed "throttling". An earlier version of the settlement was criticized by the FTC because customers who accepted the free month of service were automatically billed for additional months after the free period. The final settlement was delayed while the judge determined payments to lawyers for the plaintiffs, whose request for $2.5 million was reduced to $1.3 million for the original team that filed the suit and $60,000 for various other litigators. "We settled the case in the best interest of all parties," Netflix spokesman Steve Swasey told the Associated Press.

     

    PS - my posts up to my 5th post were on a multi hour delay, my post may have been sent before your response to onelessgod
    29 Jul 2011, 09:23 PM Reply Like
  • Maxsoar
    , contributor
    Comments (255) | Send Message
     
    Author’s reply » LyteSpeed and Scrat,

     

    Again thanks for the insightful inputs. I have sent emails to Muddy Water Research analysts (www.muddywatersresearc...), its founder Carson Block, and Citron Research analysts (citronresearch.com) telling what I have discovered so far on NFLX suggest them to take a look at this issue. Right now I think it will help to have some very reputable whistling blowing and fraud detection specialists research on this stock for all investors. If you are not familiar with the story of how these quite powerful shorting groups have destroyed many high flying Chinese stocks (some of them have more believable financial reports than NFLX in my opinion) this year, search online and read how RINO, CCME, and lately SNOFF stocks were destroyed by them in matter of days after they published negative reports on these stocks. Netflix of course has bigger market capital and supports from more I-banks and funds than SNOFF. However, on the other hand it has much higher P/E multiple then SNOFF before struck down and has brewed a bigger bubble. So, I think these two factors are pretty much a wash in terms of potential effects from Muddy Water / Citron Research attacks. Even if Muddy Water or Citron Research just publish an informal inquiry to NFLX management with a list of suspicions like they did to SPRD in June (blogs.barrons.com/tech...), I think the stock will fall to 200 or lower in a couple of days. If Muddy Water or Citron publishes a full report declaring seriously accounting misstatements in NFLX, the stock may plunge to 50 within a couple of days.

     

    I'll let you know if I heard anything.

     

    Kevin
    30 Jul 2011, 06:52 PM Reply Like
  • RobbyRob
    , contributor
    Comments (358) | Send Message
     
    Excellent analysis; the point about insider selling is especially important. Not only are they selling, but they are giving the company's CEO 5,000 shares of stock every week at the exercise price of $1.50. Who is worth 70 million dollars a year? I wouldn't invest my money with a company returning 1.5% ROC plus paying top managers a ridiculous amount of money. NFLX is going to need that 70 million per annum to pony up for new content deals!
    28 Jul 2011, 06:35 PM Reply Like
  • QJF
    , contributor
    Comments (6) | Send Message
     
    GS gave NFLX 6 month tgt $330 price, unusual time period, not faking pump. It is a prediction for the peak after NFLX complete its expansion phase.
    29 Jul 2011, 10:52 PM Reply Like
Full index of posts »
Latest Followers

StockTalks

More »
Instablogs are Seeking Alpha's free blogging platform customized for finance, with instant set up and exposure to millions of readers interested in the financial markets. Publish your own instablog in minutes.