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Bearish on Netflix, Inc. (NFLX)?

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Netflix, Inc. (NASDAQ:NFLX)Netflix, Inc. (NASDAQ:NFLX) is a state-of-the-art technology business with excellent leadership and a competitive moat that is unrivaled in the movie business. Netflix, Inc. (NASDAQ:NFLX) has learned through experience that the customer is always right. By catering to the customer (and by eliminating late fees and the competition) through advancements in technology, the entire home-entertainment market has been turned on its head. Reed Hastings pretty much single-handedly, changed the game.

Great company, bad investment

You see, I love Netflix the company even though I am a “value investment” shareholder of a direct competitor and even though I recommended shorting Netflix stock when it traded for $300 per share in 2011. The thing is, one can admire Netflix, Inc. (NASDAQ:NFLX) the company while being skeptical of Netflix the stock because of valuation concerns and a because of a highly leveraged capital structure.

The long-term picture looks bleak here, because Netflix, Inc. (NASDAQ:NFLX) has not been able to translate lofty multiples into tangible shareholder equity over time. A buyout is likely the only good possible outcome for new longs here. Over time, I expect the stock to better reflect the business fundamentals at the company. For now, this would require quite a large drop in share price for the company to trade based on fundamental analysis of future free cash flow.

Netflix recently ran up on a gigantic short squeeze and the business results don’t support the move higher. Like many technology names, Netflix trades based on emotions and hype — not on fundamentals. While I think the business is quite valuable, the company needs to address its content acquisition cost issues head on and should be sincere in preventing a second bubble in the price of its shares.

Negative book value

Netflix has a negative tangible net worth (negative book value), which is a huge red flag for any company in my view. Netflix has put “growth” above bottom-line concerns because that’s the flavor of the day on Wall Street, but over the long term any business has to make sales to pay the bills. The balance sheet for Netflix, Inc. (NASDAQ:NFLX) shows $812 million in shareholder equity; however, $3 billion of the company’s assets are in the form of content. In other words, the liquidation value of Netflix is likely negative – at least a $1 billion or $2 billion financial hole.

Cash flow problems

Cash flow leaves much to be desired: As I argued back when Netflix was trading at $300, the company doesn’t really produce free cash flow. Most of Netflix’s cash comes from ballooning payables and rising short-term debt. In fact, the big run up in the stock was based on a cash-flow statement ending March 31 that shows a $19 million loss for the recent quarter and just $2 million in “profits.” Netflix really generates almost zero cash flow from operating activities. If content costs rise in the future, the unprofitable nature of its core business could actually translate into a lower stock price.

Tax uncertainty

Additionally, the Internet Fairness Act could put the company at a competitive disadvantage – the push to tax Internet businesses at the same rate as brick-and- mortar businesses has legs and could crush the margins at Netflix, Inc. (NASDAQ:NFLX) over the next few years.

Furthermore, content acquisition costs could eat up profit margins – Netflix had a free lunch with its previous content deals but the business may end looking just as unprofitable as the movie production game over the long run. Making movies is glamorous and cool, but it’s not a great investment when movies flop.

Competitors trading for much better valuations

Netflix may generate lower profit margins in the future because of a slowing economy, the move back to inferior goods offered by the likes of Coinstar, Inc. (NASDAQ:CSTR), and a shift toward lower consumer-discretionary spending in general.

Coinstar is doing a great job of providing instant gratification at a reasonable price point despite fears about shiny discs. Consumers like not being married to a monthly subscription because the economy is weak.

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