Netflix (NASDAQ:NFLX) stock is currently approaching its all-time high of $130 per share, but that is about to change soon. The decision to short a stock or buy long comes down to how it is being valued in the market. Do you believe the market is currently undervaluing the stock? In this case you would purchase it because the market will eventually correct itself. Or do you believe the market is currently overvaluing a stock, in which case you should short it or at the very least sell? The latter is the case for Netflix. The market is so grossly overvaluing Netflix stock it has to go down soon. Insiders are selling, foreign growth is shaky at best, U.S. growth is flattening, and to top it all off, competition is catching up. These conditions make Netflix stock volatile heading into 2017 - the best option is to get out now while it is high. If you are looking to make this a profit opportunity, Netflix stock is a must short as you will soon find out why.
Saturated U.S. market and Unpredictable Foreign Future
Netflix stock has been consistently high the last two months since the 2016 third quarter earnings results were released. The truth is the stock is being way overvalued and the market has over-reacted to the company beating projections. In this article when I refer to quarterly estimations or projections, I am referring to subscriber metrics, as opposed to revenue or operating income metrics. This is because what really drives the price of Netflix stock seems to revolve around meeting or falling short of subscriber estimations. In analyzing Netflix's earning reports, when they meet or surpass revenue expectations, but fail to meet subscriber growth, the stock price still falls. And the stock price increases when they meet or surpass subscriber growth, regardless of whether they meet revenue expectations. For example, in the second quarter of 2016, Netflix projected subscriber growth of 2,500,000, but only achieved 1,677,000. For revenue, they projected $1,964,000 and actually attained revenue of $1,966,000, yet the stock price dropped drastically. A similar concept happened in the third quarter of 2015 except when flipped - revenue fell short of target but subscriber growth exceeded and stock price rose. Therefore I am driving my analysis around the subscriber growth estimations.
In this analysis I broke down subscriber growth into U.S. additions and International additions to get a better picture of the trend of the subscriber base. The estimations, according to Netflix's earnings reports to shareholders, for 2015 U.S. subscriber growth by quarter are: 1,800,000 (Q1), 600,000 (Q2), 1,150,000 (Q3), and finally 1,650,000 (Q4). Now the estimations by quarter for 2016: 1,750,000 (Q1), 500,000 (Q2), 300,000 (Q3), and 1,450,000 (Q4). Every quarterly projection for U.S. subscribers has decreased. We cannot look at the estimation trend throughout the year because typically quarters one and four have spikes. The spikes are driven by subscriptions being given as gifts, it's winter and people are inside more, and the New Year is typically when Netflix releases its new shows, so that data is inconsistent. But year-to-year analysis by quarter is useful and this trend shows that the U.S. market for Netflix is nearly saturated. As you can also note, the quarter one estimation for 2015 is relatively close to quarter one for 2016, and that is true for all of them except quarter three, where it drops over 800,000. This happened because quarter two in 2016 was so unexpectedly low. They had to severely drop expectations. Yet, 2016 fourth quarter estimations remain constant with the trend, only relatively less than the previous year's matching quarter. This leads to Netflix expecting a nearly 4 times growth in subscribers from what the actual results were in quarter three, 370,000, to what they forecast in quarter four, 1,450,000. In the last three years they have never predicted such a drastic change in subscribers from one quarter to a subsequent one, let alone achieved such growth. This brings me to my first point being that Netflix's actual U.S. subscriber growth will be drastically less than forecasted in quarter four.
The next aspect of subscriber growth are the international additions. These results are much more sporadic and unpredictable. The general trend of the expectations from 2015 to 2016 is upward with exception to quarter three. The estimations in 2015 by quarter are: 2,250,000, (Q1) 1,900,000 (Q2), 2,400,000 (Q3), and 3,500,000 (Q4). Compared to 2016's quarterly forecasts of: 4,350,000 (Q1), 2,000,000 (Q2), 2,000,000 (Q3), and 3,750,000 (Q4). As you can see, every projection from 2015 to the matching quarter in 2016 has increased, except for the super low expectations set in the third quarter. The actual results have surpassed every quarterly forecast in the last two years with exception to the disastrous second quarter in 2016. This, on the surface, seems appealing and positive for international growth and in the long term it will be.
However, since there major expansion in late 2015 and first quarter 2016 to 130 countries, the international growth has been falling. In quarter four of 2015, Netflix added 4.03 million subscribers and 4.51 in quarter one of 2016. Since then the numbers have declined to 1.52 million in quarter two of 2016 and 3.2 million in quarter three. As reported in their letter to shareholders, they are experiencing problems with China, which will be later addressed, as well as piracy, low disposable income, high competition, broadband or payment infrastructure challenges and simply low TV viewers in many other large countries. This could potentially mean that Netflix already nearly reached everyone in the foreign counties whom currently have the interest and means to view the platform. Which means reaching the people in the countries that currently have the problems listed above could be a difficult one that will take time. In the short term, I expect Netflix to fall short of their fourth quarter projection of 3.75 million new international subscribers. This, coupled with my expectation of falling way short in U.S. additions, leads me to believe the Netflix stock price will fall.
The Chinese market is a massive one with over 720 million Internet users. The country's questionable regulatory and legal framework has caused problems for many foreign companies, Netflix included. The obstacle in the Chinese market stems from the harsh censorship from their government on anything including violence, sex, religious themes, and political messages. The only reason the Netflix show House of Cards was approved for licensing is because it puts the American Government in a bad light, as corrupt and evil. So in order to even consider getting approved by Chinese government, Netflix has to create all new original series in Chinese.
The next big problem for Netflix is the intense competition in China. Their market already is saturated with streaming companies like Baidu (NASDAQ:BIDU), Youku Todou (NYSE:YOKU) and many more. Also, Netflix was beat to the market by a London-based streaming company Mubi. The fierce competition already developed in this market has boosted demand for better perks and lower prices. So in order for Netflix to overcome this obstacle, they must increase spending and lower its fees. In result, lowering operating margin, which is already declining in 2016 due to expansion costs in other countries.
All Netflix has managed so far is to get a few shows accepted by the Chinese government to be licensed to Chinese providers. This sounds like a good step, but the income from licensing is a fraction of what subscription fees revenue would be in China. Netflix CEO, Reed Hastings, recently made a statement saying its plan to infiltrate the Chinese market has failed and for now they are staying patient and playing the long game. This is a major red flag because there are numerous other huge companies such as Apple (NASDAQ:AAPL) and Disney (NYSE:DIS) that have been playing this long game for years and have yet to bear any results.
The threat of Hulu stealing Netflix subscribers is greater than most people think. Netflix recently un-grandfathered original subscribers paying $9.99 for the HD service, making them pay $11.99 for the same service. Also, the cheapest service they had, the $7.99 standard definition, is now $9.99. Hulu's lower cost platform could steal away Netflix subscribers. Hulu offers a $7.99 per month HD bundle with ads and the $11.99 package without ads. This gives viewers the option to pay less and watch the occasional ad if they are price consciousness.
Where Hulu can really draw customers in though is with the content they provide that no other U.S. streaming companies can - popular cable networks. Hulu is backed by a joint venture between Time Warner (NYSE:TWX), providing TBS, TNT, Tru TV, and so on, Comcast Corporation (CMSCA), Disney and Twenty-First Century Fox (NASDAQ:FOXA). Disney is in negotiations to license channels like ESPN, ABC and Disney Channel and Fox is in talks to bring Fox Sports and News to Hulu. All of this is coming into fruition in the first quarter of 2017. This launch will be a major threat to Netflix's earnings in quarter 4 of this year and first quarter next year, and is a major reason I believe the stock price is going to drop in a big way.
Decision to Go Short
There are a couple of things I look at when deciding to short a stock, one of them being the trend of quarterly projections. As examined above, the U.S. subscriber forecasts are declining, while the international subscriber growth is increasing for the most part. The overall effect, U.S. growth plus international growth, are the net growth expectations staying relatively close. The one exception being with the high expectations set in quarter one of 2016 due to its international launch into 130 countries. However, since that time, the expectations have been the exact same for quarters two and four in 2015 and 2016. There was a forecast of 2.5 million (Q2s) and 5.2 million (Q4s), and a decrease in 1.2 million for quarter three. Also, putting the outlier of quarter one in 2016 aside, the actual results in subscriber growth have been declining. Meaning, quarter two of 2016 is less than quarter two of 2015, and the same goes for quarter three. I expect this trend to continue into quarter four of 2016, causing Netflix to miss their fourth quarter projections, and ultimately result in the stock price falling.
Another important aspect to look at in deciding to short a stock is the insider activity. In the last three months, insiders at Netflix have bought zero new shares of Netflix stock. In that same time frame, they have sold 681,222 of their Netflix shares. The typical movements of insider trading activities is they buy stock when they believe the stock will go up and they sell when they do not think the stock will perform well in the near future. Provided they are not acting on insider information here, this activity shows the executives at Netflix do not have confidence in the stock price performing well in the near future. This idea backs up the declining trend of subscriber growth, making the short position a favorable one.
Threats To Going Short
Even with the lower ratcheting of quarterly expectations, insiders selling and not buying, shaky Chinese relations and increased U.S. competition, Netflix's short-term future is not necessarily gloomy. Much of their growth now will come from international subscribers. Therefore you could argue that Hulu is not that threatening because there is not many new U.S. subscribers to reach. Also, most likely, long-term Netflix subscribers will stay with them rather than switching over. Even with China and Netflix relationship not happening any time soon, they have still penetrated over a hundred new countries in 2016. These markets are just being tapped into. A foreign operation is always shaky grounds for U.S. investors because of the uncertainty and just generally less information available. Also, typically U.S. investors are unaware from the simple fact of cultural differences. For example, I do not know if they watch as much TV in Argentina as we do in the U.S. Further, I do not know what percent of the population in these countries even has access to the Internet and computers, whereas in the U.S. you can assume nearly everyone does. That is why, even for analysts, it is hard to predict just how much international growth Netflix will experience in the end of 2016 and throughout 2017. They could blow the expectations away and shoot the stock price even higher than it already is.
The international growth of Netflix will happen, I just do not believe it will happen in the next two quarters for them. I think they are still learning what works and what does not work in the foreign countries they recently entered. I think the fact that insiders are selling their stock right now means even they are uncertain of the growth they are experiencing in this quarter and early 2017. Add in the lower ratcheting of expectations, the saturation of the U.S. market coupled with uncertain foreign relationships, and Hulu's new platform launch in 2017, makes this stock a must short with the possibility of huge gains. To put it in perspective, Netflix stock is currently priced at $124.70. If it falls to its 52-week average price of $101.76 by the end of January when the quarter four results will have been released, that's 23% profit in a months time. If Netflix stock does worse then even I predict and it approaches its 52-week low of around $80, that's nearly 56% profit in just a month in a half.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.