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.
Coinstar, Inc. (NASDAQ:CSTR) is trading for just 9x forward earnings (13.5x trailing earnings) and revenue growth is comparable to that of Netflix over the long run — Coinstar’s revenue has almost doubled over the past two years while the stock is trading for only four times EV/EBITDA. In other words, Coinstar is a hated cash cow while Netflix, Inc. (NASDAQ:NFLX) is a much-loved money loser.
For my money, I would rather have Coinstar, Inc. (NASDAQ:CSTR)’s growth rate and profitability over the promise of a new technology. Obviously, the DVD renter is under long-term pressures from streaming, but there is no guarantee that Netflix will monopolize Internet-movie viewing. Keep in mind, Internet-connected televisions are likely the wave of the future, but DVD’s will still work no matter how many new delivery options become available to the consumer.
If you think the economic recovery and the cloud revolution is helping all Americans equally, go down to your local Wal-Mart Stores, Inc. (NYSE:WMT) at midnight and see how many folks are sleeping in their cars — I commend the company for opening its parking lots to the homeless.
Speaking of Wal-Mart’s stock, investors are receiving a 10% earnings yield compared to a zero yield on their Netflix holdings. Sure, brick-and-mortar retailers are about as popular on Wall Street as the eight-track player, but that might be a reason to be long a dinosaur like Wal-Mart Stores, Inc. (NYSE:WMT) — if everyone is already bearish on the stock, it may be a perfect time to buy. At 15x trailing earnings and 13.4x forward earnings, Wal-Mart appears to be fairly valued in my opinion and is a hold at current levels.
While the stock is fairly cheap, the growth rate over time for Wal-Mart Stores, Inc. (NYSE:WMT) could slow because of market saturation and the conscious choice of consumers to buy locally. Quarterly revenue growth of 3.6% is not all that bad, but I don’t expect record high 22% profit margins to last forever.
Netflix could also be punished for helping to bankrupt the U.S. Postal Service – the US Postal Service has already cancelled Saturday delivery and its looking more and more like the Post Office needs to start adding additional fees for handling red envelopes. No one knows when the Post Office’s day of reckoning will come, but it appears that when the public sector institution has to compete with the private sector businesses, the private sector almost always wins.
The bottom line
In conclusion, the stock has come too far too fast and is due for a correction. Just a few months ago Netflix was trading at under $100 per share, and last year could be bought for $50 and change. Certainly Carl Icahn is smiling, but he’s also likely selling into the massive short squeeze rally.
The stock could run back up to $300, at which point I think it’s a “no-brainer” short. This movie has already played in a theater near you – last time dropping from $300 to $60 a share. History doesn’t repeat itself, but it often rhymes. What is so much better about today’s Netflix than last year’s Netflix? It’s not profitability, tangible book value, or free cash flow per share.
Alas, I find both Wal-Mart and Redbox parent Coinstar to be better investments right now. Both are trading at more reasonable earnings multiples than Netflix, Inc. (NASDAQ:NFLX) is right now at 500x earnings.
The “new new new” market reality is not about fundamentals as much as it is about hyperbole so make sure to keep in mind that over the short run anything is possible.
The article Time to Sell Netflix originally appeared on Fool.com and is written by Nicholas Southwick.
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