Netflix, Inc. (NFLX) Is a Sell Out of the Gate: Axiom

Netflix stock has a hard time with overvaluation. Spending more than it's collecting isn't helping matters.

Stock research outfit Axiom doesn’t deny that Netflix, Inc. (NASDAQ:NFLX) has several things working in its favor, like its award-winning original content and the fact that it’s the market leader. (Largely because Netflix built the on-demand, over-the-top category itself). On the other hand, with costs soaring and competition on the rise, Axiom sees no choice but to begin its coverage of Netflix stock with a “Sell” rating, suggesting a target price of $80 for NFLX.

That’s 18% below Friday’s closing price for Netflix stock.

The opinion has already ruffled some feathers among diehard Netflix investors who love the growth story. They are quick to point out it was just Friday when RBC Capital Markets sang the company’s praises, reiterating its $130 target price for NFLX stock.

Moreover, on Monday morning, BTIG Research forecast Netflix would garner 6.58 million new subscribers (worldwide) in the second half of 2016, versus the 83 million it currently has.

Axiom may have a point, though. Costs and long-term liabilities are reaching uncomfortable levels.

NFLX: Not Like It Used to Be

Giving credit where it’s due, Netflix is still the king. In a recent J.D. Power survey, it edged out rival Hulu in terms of overall satisfaction. It was alarmingly close, though. Netflix scored a total of 829, and Hulu scored 821. Vudu, owned by Wal-Mart Stores, Inc. (NYSE:WMT), was surprisingly competitive with a score of 810.

Missing from the mix were relatively young SlingTV, from Dish Network Corp (NASDAQ:DISH), and a very new service from Sony Corp. (NYSE:SNE) called PlayStation Vue, both of which offer a blend of network broadcasts in addition to a wide variety of on-demand content. Netflix holds a commanding lead on both in terms of market share, but the fact that Vue and SlingTV were able to launch and attract users at all makes it clear that consumers are ready to consider other choices.

In other words, NFLX has some real competition it didn’t have before. Axiom’s call simply acknowledges this reality, even if other observers see the current Netflix as the competition-free Netflix of yesteryear.

It’s ultimately a matter of math and the business model. Netflix leases a lot of great content from studios, and what it can’t find, it makes for itself. House of Cards and Orange is the New Black are just a couple fan-favorite originals.

It’s good content, but it’s not cheap.

Netflix Stock Weighed Down by Costs

Netflix will spend $6 billion on its own programs this year. For perspective, the company has generated $7.6 billion worth of revenue over the course of the past twelve months.

Entrenched owners of Netflix stock will point out that it’s an investment that’s paying off. The company reported income of $40.7 million last quarter on $2.1 billion in revenue. The figures were up 54% and 27% on a year-over-year basis, respectively.

The figures don’t tell the whole story, however — the way Netflix books the expenses for its content can obscure the math. The operational cash flow for the quarter was a negative $226.3 million, which marks eight straight negative cash flow (operating) figures … most of which have been sequentially bigger than the previous total.

And with that as the backdrop, the question of expenses versus revenue growth arises.

In a nutshell, as fast as the top line is growing, content liabilities and expenses are growing even faster, including non-current (future) liabilities. The chart below plots the changing fiscal situation for Netflix.

Netflix Balance Sheet, Income Statement Data
Click to Enlarge

Something has to change soon; the current math doesn’t make sense for Netflix stock, which is presently trading at trailing P/E of 305 and a forward-looking P/E of 110. Neither are even in the realm of being close to reasonable.

Bottom Line for NFLX

For the record, CEO Reed Hastings has said the company will become meaningfully profitable in 2017, presumably with a combination of more subscribers growth and relatively less spending on … well, everything.

It leaves one wondering, though: Does the company’s subscriber growth ultimately depend on spending growth? Hastings doesn’t seem to think so. Or, at least he’s not saying it.

Whatever the case, even if NFLX is capable of curtailing its costs and growing its headcount, the triple-digit P/E ratios don’t leave room for much upside — particularly with SlingTV, Vue and Hulu making waves — even if Netflix performs heroically beyond 2017.

Axiom is just asking a good question, and answering it with a plausible response.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

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