Netflix Stock: Why You Should Sell Netflix, Inc. (NFLX) Stock Now

  • If you compare pre-revised analyst estimates for Netflix and Q3 results, Q3 is not impressive.
  • Raising questions of whether Q3 beat justifies the new stock price and heightened valuations.
  • Investors would be better off by selling the stock if they own it and not buy the stock if you did not.

My current thesis on Netflix Inc. (NSDQ:NFLX) is relatively simple. I think the recent 20% rally in the stock will be short-lived. This is not to say that Netflix will not be able to gain momentum again but to imply that although Netflix outperformed this quarter, the expectations it exceeded were, in fact, reduced expectations.

If you look back to May of this year, Netflix's stock price took a 12% nosedive after the company issued weaker than expected subscriber growth forecast. Netflix announced that they would add 2 million international subscribers and 0.3 million domestic (U.S.) subscribers. But according to FactSet, analysts were expecting Netflix to add 3.5 million international subscribers and 0.6 million domestic subscribers.

If you compare these initial expectations and had Netflix not lowered their expectations, Q3 results could not have generated the 20% increase in Netflix's stock price like it did. For example, in Q3 Netflix added 0.4 million domestic subscribers versus the initial analyst forecast of 0.6 million domestic adds. Same applies to international adds, Netflix was able to add 3.2 million international adds relative to the 3.5 million adds initially expected.

Now if you compare what analysts were initially expecting relative to what Netflix achieved (ignoring the fact that they reduced expectations mid-way), you realize that Netflix could have missed international and domestic add expectations by ~33% and ~9% respectively.

This comparison raises two very important points:

  1. Does the earnings beat in Q3 (considering they are lowered expectations) justify the new higher valuations?
  2. Will Netflix's plan to increase its credit risk amidst higher valuations justify the new stock price?

In the following notes, I will try to tackle the above questions starting with the second question.

The Higher Credit Risk

On April 29th, 2016, I wrote an article entitled, "Factoring Credit Risk Into The Netflix, Inc. Thesis." I explained why Netflix's need for cash infusion to support its accelerated original programming appetite could negatively affect its valuations. Netflix's aggressive investment in original content is based on the expectation that this new content should help them retain existing customers and help them attract new customers as they continue to expand globally.

But the recent results makes my April thesis weak. Let me give credit where it is due. Netflix's Q3 results came in above expectations. Here is a run down of some of the key achievements from this quarter as reported here.

  • Netflix has "un-grandfathered" 75% of its members. This means that churn rate might go down as more price sensitive customers have been weeded out.
  • Brought in 0.37 million net domestic subscribers relative to Wall Street estimate of 0.304 million and its own expectation of 0.3 million.
  • Issued subscriber adds in the top range of most estimates for Q4 (0.52 million domestic and 3.75 million international). For a company whose expectations were severally lowered, these estimates renewed faith in Netflix's future.

However, Netflix has doubled-down on the content needs and plans to borrow more money. One excerpt from Netflix's Q3 that might go un-noticed but needs deep scrutiny is this one;

"So, over time though, we anticipate that we could get and would optimize our cost of capital up to a 20% leverage ratio. And we're talking about a debt to market cap at that point, but I think we will be closer to an EBITDA basis as well because the business is growing and operating income and EBITDA." - David Wells

Can Netflix justify the high spending with actual profits?

Everyone seems excited about subscriber numbers (which is good as more subscribers means more money), but given that Q3 subscriber beat was lower than earlier estimates (higher than revised estimates), is a $20 million beat in revenue that impressive?

Last week, it was reported that Netflix will pay Chris Rock $40 million for two special shows that will be taped in 2017. That cost alone makes the $20 million revenue beat less impressive.

In addition, Netflix has a cash burn problem. It used up $462 million net cash in operating activities in Q3, more than twice the $226 million used in the second quarter. Because of its cash burn problems, Netflix will become riskier as it increases its debt.

The Valuation Question

In addition to its cash burn problem and a potential for higher credit risk (due to a need for more cash infusion), Netflix's recent 20% rally means that it's expensive valuations have become even more expensive. Let me put it into perspective. As it stands at ~$120/share, Netflix now has a) a market cap of ~$50 billion, b)trades at ~312x  ("TTM") price to earnings ratio and c) trades at ~128x forward price to earnings ratio

As you can see, estimates seem to be blown out of proportion. These numbers make more sense when put next to the industry averages.

Source: Morningstar

Capture

A quick run-down of the comparisons is as follows:

  • Netflix's P/E ratio is ~92% higher than its industry average
  • Netflix's Price/Sales ratio is ~ 81% higher than the industry average
  • Netflix's forward P/E ratio is ~85% higher than the S&P 500

Now there is no evidence to justify the fact that Netflix can beat the broader market by ~85% or why its P/E ratio should be 92% higher than its industry average. These heightened valuations might have different meanings, one of which is that Netflix's 20% rally might not be sustainable. Meaning that it could be optimal to sell the stock and take profits if you owned it and avoid buying the stock if you did not.

Remember that the return from Netflix's higher spending is mainly based on estimations. They hope that the more they invest in content the more subscribers they can retain and the more new subscribers they can acquire. But competitors are also investing in content. Amazon, for example, plans to double its video content spend in the second quarter of this year and triple its spending on original content. Netflix cannot outbid Amazon in a spending war.

Besides legit competitors, a lot of illegal streaming sites where you can watch any of your favorite shows are everywhere online. This presents more competition for Netflix as more potential paying subscribers might opt for free streaming especially if they are not avid movie watchers. This should make investors wary of the sustainability of Netflix's new valuation given the recent rally in the stock price.

Conclusion

There is no evidence to suggest that Netflix will be growing aggressively in the long-term. Its next growth frontier is outside the U.S. market, and one of the biggest markets outside the U.S. (China) has not proved lucrative. In its  shareholder letter, Netflix acknowledged that "the regulatory environment for foreign digital content services in China has become challenging. We now plan to license content to existing online service providers in China rather than operate our own service in China in the near term."

The lack of "aggression" in its future growth rate means that we cannot assign such higher valuations to a company whose growth rate will be low or likely to plateau. The future of streaming will be content. This is why Netflix is so eager to invest heavily in content. But it is going to be hard for them to beat highly capitalized competitors such as Amazon, Disney or HBO, implying that Netflix's market is not as unique. The market is getting saturated. The aggressive valuations of Netflix stock are unlikely to be sustained.

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  • I do not have any business relationship with the companies mentioned in this post.
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