Description

The bull case on NFLX has been previously written up in substantial detail by finn520.  I credit him with doing a good job giving an overview of the business, identifying a cheap stock and an ok business that was priced like a bad business and I now urge him to take his big win.  I will do my best to convince him that pigs get slaughtered below.  Since he did a great overview and not much has changed, I will refer you to his overview for the business description.  My short thesis is below.

Investment Thesis: 

Netflix is pricing in near-perfect execution of a difficult transition from a profitable mail-order DVD business to a much less profitable and more capital intensive streaming subscription business.  In addition the streaming business faces numerous competitors many of which don’t have profit (on streaming) as their primary motive (e.g. Amazon, Comcast).  The stock is wildly overpriced and any number of missteps will derail it.  In addition, you just saw a short squeeze.  My preferred way of shorting this one is with a put spread.  Netflix is not a zero, it just is wildly over-valued and faces numerous threats to its business model in the near-term.  A put spread can capture this view better than an outright short and with less risk.  We have all seen that sometimes the valuation won't protect you on the short side (see Amazon.com).  If Netflix does not stumble due to increased competition and the end of a near-term short squeeze it could stay overvalued for a long time.

Netflix is transitioning from a high profit (50% contribution margin) business with DVD rentals to a low margin business in streaming (domestic streaming has a 18.5% contribution margin at 3x the subs as DVD).  The DVD business lost 2 million subs in 2012.  Managing this transition is going to be very difficult for the company and they will probably trip several times along the way – they already have once with the announcement that DVDs would be spun-off as Qwikster.  U.S. Postal service is a critical service provider for the DVD business and their fiscal situation ($16 bil loss last year) is going to necessitate cost increases for Netflix over time and probably soon.  A change in service (to less than 7 day a week delivery for instance) could materially harm the Netflix DVD business.

The competition Netflix faces online is intense.  Amazon.com offers unlimited free streaming with Prime membership which costs $79 ($6.58/mo) for the year and includes free 2-day shipping on all Amazon orders as well as free library rentals for Kindles.  It is clear that Amazon prime members spend more with Amazon shopping so streaming is really just an incentive to get more Prime members.  Redbox began offering instant video in partnership with Verizon wireless at the end of last year.  The Red Box package is $7.99 per month but also includes 4 Red Box DVD rentals each month.  This service does not offer TV shows though.  Comcast offers XfinityTV to their subscribers as part of their cable subscription.  It allows instant streaming of movies and shows shown on cable.  Comcast is most concerned with keeping cable subscribers $70-$100 per month than streaming.  HBO Go offers access to all shows and movies online to anyone who is an HBO subscriber- usually $10/mo through cable provider.  (Someone combining HBOGo with Xfinity would have all their bases covered). It is easy to see Comcast would use streaming as a retention tool.  Hulu is a JV between FOX, NBA, and ABC offering streaming of current and old shows for $7.99 per month.  Don't forget the Dish/Blockbuster service either.  To me, all this competition means the economics of Internet video providers are going to be worse than for current pay TV providers where the customer usually only faces two choices (cable or satellite) and churn is a lot lower.  This is the critical point.  Why should Netflix have margins any higher than DTV or the cable providers in the end?  Both have to buy content from the same guys.  DTV, like Netflix, has a lot of operating leverage once the bird is in the air.  Yet their EBIT margins are only 18% despite having ~35 mil global subs and much higher ARPU subs than Netflix.    Netflix should suffer particularly because they neither own the content or the means of distributing it (cable or phone infrastructure to the customers or even servers - Amazon provides those to NFLX via AWS).  Combine that with competitors like Amazon and Comcast that are offering streaming as a sweetener and not to make money and it could be a toxic brew.  If anyone knows John Malone, I'd like to know if he'd buy Netflix here.  My money is on "No."

Fixed price content agreements.  Netflix frequently enters into long term agreements for content (e.g. recent Disney deal).  To do this successfully, Netflix must have a strong view on how many subs they have in 3 years plus.  Given the fluid dynamics of the Internet TV space, this seems like a difficult task.  Furthermore, Netflix has always had a high churn rate of at least 3.8% per month (they stopped reporting this number in 2012) which implies Netflix would lose ½ their subs in 18 mos if they stopped acquiring new customers.  If Netflix were to misjudge their subscriber count they may find high fixed costs and lower sub counts to be a significant problem for them.  So far streaming subs have gone only one way for Netflix.  If that remains the case all will be well, but if it changes their business could become imperiled rather quickly.  The “virtuous cycle” looks like a two way street from perspective.  Did I mention Reed Hastings was talking about taking on more debt on the last conference call?  Layer the financial leverage on top of operating leverage and if subs get off track for any reason its not going to be pretty.  There was a time when the subs for the DVD business were only going one way remember.

Exclusive content.  Netflix has begun to pay producers for exclusive content.  We all know developing hit shows is a very tough business.  It is great when it works, but is really bad when it doesn’t.  It can sure waste a lot of money if you let it.  HBO has been doing it for years, it is unrealistic to think that Netflix is going to be great at it out of the gate.  They are going to have to come up the learning curve and that will cost them money no doubt.

Lack of Pricing Power.  This was definitevly demonstrated with the management price hikes that blew up sub growth permanently for DVDs and on the Internet for a while.  Don't expect these guys to hike rates again anytime soon.

Risks:

Internet video is a better mousetrap.  It is true that streaming any show you want instantly is a better experience than DVDs or even a DVR.  People are going to adopt this mode of watching.  The question for Netflix is will they be able to keep their early lead and their profits?  Given how easy it is to switch providers on the Internet, the barriers seem low.

There is a huge short interest in the stock (25%).  The 60% rise in the last couple days shows what a short squeeze can mean.  The short interest will keep the stock very volatile.  

There are examples of Internet businesses with negligible profits and huge valuations.  See Amazon and Facebook.  If the business does not materially deteriorate in the next year or two, watch out.

The new exclusive content that Netflix is investing in may really drive subs.  HBO certainly has shown it can be done.  

Currently Netflix has the best library of content of the major online only providers.  While Amazon has been improving quickly, Netflix will no doubt try to stay ahead and if they do it may be good for them.

Acquisition risk.  Someone who decides they have to be in the online video business could buy this (please don’t do it MSFT).  Given that their entire platform is built on Amazon Web Services, I am not sure why someone with data center expertise would pay up, but dumb things do happen often.  In terms of Icahn, NFLX nuetered him with the poison pill and he probably booked his profits already.

Watch out for the "virtuous cycle."  As I said, I think it will end up cutting both ways.  It certainly did in 2012 vs. 2011.

Valuation:

I can't even go here except for to say that I find Netflix to be expensive any way you measure it.  Shorting on valuation is not a good idea though, so short it for the competitive realities, the end of the squeeze, and continued horrible cash flow results.  Know that the valuation is on your side. If someone else can show math where it isn't I'd like to see it.

Disclaimer:  Nothing I say above should be relied upon or construed as investment advice.  We or our affiliates do hold a position in the security mentioned above and may change it any time without notifying anyone.  Do your own work folks.

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