While Netflix’s (NFLX) underlying business is sound, we believe that a short position in Netflix is warranted because the stock is priced to perfection.
If we assume that every household in the US subscribes to Netflix, our “blue-sky” valuation only values NFLX’s business at $300 a share (and that is assuming every US household becomes a subscriber, which is not going to happen) and over time fair value probably lies closer to $70 or $80 in the event that material competition continues to enter the streaming content space at a rapid rate.
Netflix’s current valuation assumes a near-perfect growth trajectory of the company’s earnings over the medium-term and there is therefore a significant chance of multiple compression if any of the points discussed below were to transpire. Our primary thesis for this short, however, relates to the strong likelihood that current 2011 and 2012 sell-side estimates for the company are at risk of being missed.
The main drivers of our short thesis are:
- The recent capitulation of the most vocal short on NFLX (the respected hedge fund T2 Partners) – it is always encouraging to put on a position when its most adamant advocate is stopped out of it, more often than not this happens at times of extreme pessimism or optimism.
- 2011 estimates at 53x P/E, 24x EV/EBITDA, 4x Sales, negative FCF yield and 30x P/BV is hardly a valuation that anyone should be buying any security at – unless we believe we found the next Apple (AAPL) or Microsoft (MSFT). But Netflix is not it.
- There are very few, if any, barriers to entry in this business and competitors include Amazon (AMZN), Comcast (CMCSA), Apple and the major studios. This is what happens to good business models with low barriers to entry; competitors will not sit and watch Netflix take the whole pie. To make matters worse the competitors coming to this party are serious and much better capitalised than NFLX.
- Charges for internet downloads are set to increase. Currently, approximately 20% of broadband traffic during peak hours in the US is Netflix related, the broadband suppliers have already stated that as a worry, and we believe that steps to change that (by introducing usage fees) are imminent. Netflix could be the catalyst for the end of unlimited broadband packages in the US.
- Content providers have already stated their dissatisfaction with the current contract terms with NFLX to distribute their films. Expect much tougher prices going forward. This can only lead to margin compression as we don’t believe NFLX will be able to keep adding as many subscribers if the company tries to pass on the increased costs to clients.
- The internationalization strategy will be expensive, difficult to implement and will distract management from focusing on their home business while under attack from extremely well capitalised new entrants. Brand awareness overseas could come at a very steep price for NFLX shareholders.
- With the Sell-side and TV pundits referring to “new measures of valuation” to value Netflix – it starts to sound like 1999/2000 all over again…
- NFLX trades 10% of its investor base per day – this is not the beginning of a “new new” thing but rather the pinnacle of it.
The stock is currently being propelled higher by a significant amount of momentum, which we believe has been led by recent bullish reports by 2 prominent brokers. Current valuation may persist for a while but ultimately we believe the risk/reward will favour our short investment in Netflix. We believe that there is a material chance that the company delivers 2011 EPS that is 20%+ below the current Street GAAP estimate of $4.52 and with the likely multiple compression that would result from such an earnings miss, we feel that the shares could easily fall to the range of $135 – $150, from the current level of $240.
Disclaimer: Noster Capital Fund is short NFLX shares at the time of this post
Disclosure: I am short NFLX.
This post originally appeeared at Seeking Alpha.
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