After management gave a dismal view of the future Monday, Netflix (NASDAQ:NFLX) shares tumbled 35% Tuesday. Although revenues actually were 49% higher for the quarter, the combination of rising fees to TV and movie studios and higher-than-expected customer defections led the company to forecast losses for the next year.
Alas, such is the fate of a fallen glamour stock.
My words yesterday about the beleaguered Netflix were, unfortunately, prophetic. I wrote,
Chasing trendy stocks is a risky business. Consider the case of Netflix. Earlier this year, the former growth stock darling could do no wrong. The company that put Blockbuster into bankruptcy with its DVD-by-mail business was aggressively expanding its Internet streaming offering. But why anyone would pay a premium multiple for the stock was a mystery to me. The company had no competitive advantage, or what Warren Buffett likes to call “moats.”
Netflix is not Coca-Cola (NYSE:KO). Unlike Coke, it does not have an indestructible brand that can withstand a very bad miscalculation by management. Coca-Cola could survive something as idiotic as New Coke, a major product upheaval that customers neither wanted nor needed. Netflix, however, might never fully recover from its premature decision to cut the DVD-by-mail business loose.
It wasn’t always that way. For a brief window of time, Netflix did appear to have a competitive advantage. The DVD-by-mail business was a quirky idea that just happened to have perfect timing and, once established, was very expensive for a would-be competitor to replicate. Alas, it wasn’t durable; it had a very finite shelf life.
In the late 1990s, streaming video still was in its infancy and was not ready for the mass market. Too few Americans had broadband connections, and even if they did, they lacked access to Internet-ready TVs and DVD players. And again, even if they had such devices, movie studios were not yet prepared to make their content available over the Internet. Movie watchers still were dependent on physical media, and for those who liked the convenience of home delivery, the DVD-by-mail service was a perfect fit.
Today, a decade later, it seemed anachronistic and almost quaint to physically mail something that can be quickly delivered digitally; this is the age of the iTunes song and the Kindle e-book. Netflix’s management realized this and was right to de-emphasize the DVD-by-mail business and corral its customers into the Internet streaming service. But the move to split the company into two separate sites — and dramatically raise prices in the process — was moving too far too fast. And with no competitive moat to prevent customers from going to rival services like Hulu Plus or Amazon‘s (NASDAQ:AMZN) Amazon Prime, Netflix suddenly looks very vulnerable.
I’m not going to join the bandwagon of those bashing Netflix and CEO Reed Hastings. Mr. Hastings is no fool. He is a tech visionary who took his company a long way, and I believe he will find a way to work through this. Even the late Steve Jobs, regarded by many as a tech demigod, made a few mistakes over his illustrious career. In the rough-and-tumble world of capitalism, it happens.
No, the real fools are those who paid $300 per share for NFLX less than five months ago. Until the recent slide, Netflix sported a valuation that was reminiscent of the late 1990s dot-com bubble. Even as late as yesterday, it had a price-to-earnings ratio of over 30. Investors who paid that kind of multiple for a business with no clear advantage over its deep-pocketed rivals — and whose profitability depended on the good nature its suppliers, the cash-strapped movie and TV studios — can’t blame Mr. Hastings for their misfortune.
As I wrote yesterday, “when you invest in what currently is trendy, you are playing a risky game of musical chairs. It can be a lot of fun — until the music stops and you find yourself without a chair.”
Alas, NFLX investors find themselves today without chairs.
Netflix might present an opportunity for value investors — eventually. But we most assuredly are not there yet. Even after last night’s bloodletting, the stock is not “cheap.” And as experienced investors know, it is a disaster to attempt to catch a falling knife. I believe the company will survive and eventually thrive as one of many streaming options. But buying the company today is a mistake.
I recommend investors check in on Netflix in six to 12 months. That should be plenty of time for the selling by growth investors to run its course. By that point, NFLX stock might — might — be a good value play.
Charles Lewis Sizemore, CFA is the editor of the Sizemore Investment Letter, and the chief investment officer of investments firm Sizemore Capital Management. As of this writing, Sizemore did not have a position in any of the aforementioned stocks. Sign up for a FREE copy of his new Special Report: “3 Safe Emerging Market Stocks for a Shaky Market.”
