Have We Already Seen Peak Netflix?

| About: Netflix, Inc. (NFLX)
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Summary

Netflix achieved about 75 million subscribers by the end of 2015, and there appears to be no slowdown in subscriber growth.

However, Netflix profitability suffered in 2015 as the company took on more debt.

Netflix could post a net loss before taxes some time in the coming year, if the current trend continues.

This loss could further depress Netflix's shares, ending its status as a momentum stock.

As of its 2015 Q4 earnings report, Netflix (NASDAQ:NFLX) continues to add subscribers at an impressive rate. Whether this will continue to satisfy investors is questionable. There are already signs that this momentum stock has peaked.

Source: Google Finance

The Netflix Thesis

Before the latest earnings release on January 19, Paul La Monica wrote in CNN Money that Netflix had better meet a subscriber target of 75 million for the end of the year. It didn't quite do that, making 74.76 million, but the number seemed to satisfy investors. La Monica's article made me realize that the secret of the success of Netflix as a momentum stock may be that it has an investment thesis that anyone can understand: as long as membership keeps growing at more or less a constant rate, the stock price does as well.

Membership has grown consistently since 2013, with some slight seasonal variation, as shown in the chart below.

However, there are signs that the share price may have peaked. Netflix is down about 19% from its 52-week high of $133.27, which was reached in early December.

The Disruption Problem

Of course, there's more to the sky high valuation of Netflix than a simple investment thesis. As an Internet-based distributor of video content (both purchased and original), Netflix has led the disruption of the traditional broadcast TV model. As I've written before, the future of all digital content distribution is the Internet, and I expect most of the traditional TV broadcasting to transition to Internet distribution. That transition is already underway.

Although Apple (NASDAQ:AAPL) already had developed iTunes for Internet distribution of purchased and rented video content, Netflix seems to have hit the sweet spot of consumer affordability with its subscription streaming model, another element of its disruptive character.

It doesn't even seem to matter that subscription streaming is an easily duplicated business model (Amazon (NASDAQ:AMZN) Prime, and Hulu). Netflix's domestic subscriptions have continued to grow at a constant rate despite the growth of Netflix's competitors. Partly this is a result of the fact that the market is still unsaturated, and partly this is a result of the fact that the services are not necessarily mutually exclusive. The services are so inexpensive that a consumer can have several for the price of a minimal cable package.

Disruptive technology companies automatically seem to have inflated valuations, although Netflix is in a class by itself with a P/E of 380.6 (according to Google Finance). I believe this is partly the result of the very high institutional ownership of 83% (also according to Google Finance). The very high institutional ownership in effect creates a scarcity of the stock for retail investors.

The disruptive character of Netflix, combined with high expectations for future growth make assessing the "true" value of the company pointless. About all one can say with confidence is that Netflix probably isn't worth what the P/E implies.

Loss of Momentum

Should momentum investors in Netflix even care if it isn't worth the P/E implication? Right now, I think most of them don't (including the institutions, who probably take a more cynical view of Netflix). But there's a very immediate reason for Netflix investors to be concerned about the stock's momentum, and that's the trend in Netflix's operating income since it peaked in 2014 Q2:

Also shown in the chart is net income before taxes. The trend, especially since the beginning of 2015, has been downward. What's been forcing operating income down has not been the decline in revenue, of course, but increasing operating costs for things like Marketing, R&D, etc.

That's not the worst problem that Netflix faces. It could be argued that Netflix could trim back operating expenses once it's finished with its global expansion, whenever that might be. The more serious problem in my view is that Netflix added dramatically to its debt costs in 2015, so that it pays about $35 million in interest every quarter. This is reflected in net income before taxes.

Netflix's total long-term debt of $2.3 billion is now greater than its equity of $2.2 billion. As of the latest earnings report, Netflix's management indicated that they intend to borrow even more money in the coming year, further depressing net income. If the income trend continues, Netflix will begin to lose money in about a year.

Investor Takeaway

It's clear that there's a race on to expand globally, achieve the highest level of subscribers, and produce the most compelling content. It's also clear that Netflix has no hope of winning this race if it doesn't spend heavily, necessitating the borrowing. There's a belief among Netflix investors that near-term profitability can be sacrificed to achieve the long-term goal of global domination of the market.

Certainly, Netflix is very sticky. I still have a subscription, although I find I use it less and less. Yes, some of the Netflix original content is marvelous, but everyone has started developing original content, so I doubt that will be a positive discriminator indefinitely.

Recent concerns about ratings, and the lack thereof, probably amount to just the tip of the iceberg of concerns that the institutions are starting to have about the long-term viability of Netflix. In effect, they want to know if the money being spent on original content is actually achieving a reasonable return. The original content being produced by Netflix is probably unique in the entertainment industry in that there's no visibility for investors into how well the content is actually doing financially.

In traditional TV and movie production, there's fairly rigorous cost accounting that provides visibility to the relative success of the productions to investors. There are also other feedback mechanisms such as ratings and theater ticket sales that investors can look at. With Netflix, investors get none of that.

It can be argued that the point of the original content is to increase the overall appeal of Netflix and not to earn a profit on a particular program or series. Given the financial structure of Netflix, it's not clear that program profitability can even be meaningfully defined. But even at the big picture level, Netflix's profitability doesn't look all that great, as I point out above.

What Netflix investors need to be concerned about is the question of when do the institutions start to pull out, because that's a really significant increase in the supply of shares hitting the market. What would be the trigger for the institutions to cut back ownership? Probably when net income before taxes goes negative.

Probably that will happen in the coming year, if the current trend continues. At the point that the institutions start dumping their shares, it may already be too late for retail investors. Therefore, I consider Netflix a sell at the very least.

There's probably a short opportunity here as well. With the stock so highly valued and the potential for a very rapid deflation of the stock based on an institutional selloff, shorting the stock could be highly profitable. This will depend on a continuation of the downward trend in income, and probably short interest will grow throughout the year.

Disclosure: I am/we are long AAPL.

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.