The debate over Netflix (NFLX) is not going to end anytime soon. There are perma-bulls and perma-bears, each pressing their arguments. Thing is, it was one thing to dismiss the bears when NFLX stock was at $80 and the path of least resistance was up.
However, then Carl Icahn piled in and everything went nuts, and now the path of least resistance seems to be down.
See, the problem is, the fundamentals of the business haven’t changed much during the stock’s run to $380, so even after a quick dip to “only” $340, it’s high time to ask whether NFLX stock has seen its top.
What’s Wrong With NFLX?
First, a quick review at the fundamentals and why I think they are bearish for Netflix stock.
For one, the DVD business is effectively dying. Netflix’s DVD subscriptions have dropped from 11.7 million in Q4 2011 to 7.1 million in Q3 2013. Revenue in that segment fell from $370 million to $221 million over that time.
That’s because streaming is not merely the future, it is the immediate future. Amazon (AMZN) and Apple’s (AAPL) iTunes are demonstrating this, and of course NFLX is too.
Netflix domestic streaming customers did jump from 25.1 million to 31.1 million year-over-year, with commensurate increases in revenues and contribution to profit. However, the expense NFLX incurs from expanding its international streaming wiped out a lot of that profit.
The problem is, the streaming business is just not generating enough revenue. Net operating profit for NFLX stock for the first nine months of 2013 was $64 million. Operating cash flow was $56 million, but then NFLX stock went cash flow negative given DVD content acquisition costs. This will improve, but at $8 per month, Netflix will never be priced accordingly. Streaming pricing will have to increase.
All this doesn’t even tackle the ultimate, never-addressed conundrum for NFLX stock: Netflix has several billion dollars in off-balance sheet obligations for content that it will not be able to pay for.
As mentioned, NFLX has to compete with Amazon and Apple, which have billions of cash to outbid NFLX for premium content. NFLX now must also battle with the Outerwall (OUTR)-Verizon (VZ) partnership. Verizon has billions of cash on its balance sheet. Meanwhile, Netflix has a little more than a billion, and that must be spent toward the current content obligations! None of this mentions Hulu, HBO Go Prime, or Sony’s (SNE) offerings.
Netflix’s push into original programming will not save it. For starters, it costs a lot of money to produce these shows (even though I love House of Cards), and NFLX refuses to offer transparency on how many subscribers these shows actually bring in. (My own two cents: I don’t think Netflix has a way to measure it.)
Don’t Pay for Disaster
Taking all this into account, as well as long-term growth estimates of 22.5% … does it sound like investors should be paying 84 times 2014 estimates?
Because that’s exactly what they’re doing right now.
Netflix stock is outrageously overvalued. That much is certain. But also consider the fact that NFLX faces a few short term concerns.
Netflix stock has recently breached its 100-day moving average. And then there’s the very realistic possibility that Carl Icahn must be considering selling given a five-fold gain.
Again, I see the path of least resistance as being down, not up. I think investors should sell now, and consider shorting if the stock breaches the $320 level.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at firstname.lastname@example.org and follow his tweets @ichabodscranium.