Bearish on Netflix? Join the club

The stock is a current momentum darling, but feels overpriced.

By InvestorPlace Nov 5, 2013 12:35PM
Netflix login screen. © Mike Blake/Newscom/ReutersBy Carla Lake

iplogoIf Netflix (NFLX) doesn't screw up, its chart might never come back to earth.

The stock has surpassed the nosebleed levels of 2011, right before the company crashed and burned trying to spin off its DVD business.

Unfortunately for Netflix, it won’t take that big of a screwup this time around to spark a sell-off. So investors need to tread lightly here.

Market darlings crash and burn in the blink of an eye when they're no longer trading on fundamentals. And Netflix is clearly a darling right now with award-winning original content, significant subscriber growth and improvements to the top and bottom line.

That's why Netflix stock is up 250% year-to-date.

But the big growth has made the stock quite pricey; it's valued at 16 times book value and  its forward P/E is closing in on 100X.

That's why making a bear call at these levels is pretty common right now despite the big run.

  • Bernstein Research's Carlos Kirjner has expressed concern over Netflix's prospects overseas, even with the 6.2% international streaming growth beat.
  • Charles Sizemore of Sizemore Capital Management is unconvinced that first-mover Netflix will be the last man standing once other companies catch up to find more efficient, more profitable ways to offer on-demand, always-on programming.
  • Investorplace's Jeff Reeves writes that Netflix's addressable market is limited due to the need for high-speed Internet.
  • Even Netflix CEO Reed Hastings noted that NFLX is overvalued, saying, "we have a sense of momentum investors driving the stock price more than we might normally" in the NFLX earnings interview transcript.

High costs of doing business

So does all of the bearish press have a point?

Aside from over-optimistic traders, Netflix’s underlying problem is that it’s just beginning to become a business that actually makes something -- original video.

Out of the gate, the content is strong, but Netflix is new to this game, competing with deep-pocketed companies like Time Warner’s (TWX) HBO on premium content.

Since there’s not much difference between the apps for HBO Go, Hulu Plus and Netflix, it’s all about content. And Netflix is running uphill.

The contribution to margins for Netflix streaming video subscribers are actually slimmer than for their DVD business because the company is spending big on original content, existing licensing contracts and expanding to new licensing contracts domestically and internationally.

In the third quarter, for instance, additions to the streaming content library added up to over $870 million, 17% more than the year-ago quarter. In other words -- you have to spend money to make money, and Netflix is definitely putting a hefty investment in customer retention and growth.

All of these costs are a heavy weight to drag while trying to run ahead of the competition, especially when the company depends on so many factors outside its control, from customer experiences on third-party Netflix apps to hoping no one else builds a better mousetrap.

International growth

Among the factors Netflix can control, the one that seems like it could make the most difference for Netflix is international growth.

Domestic subscriber growth is ticking along, and will probably will continue to do so as long as there are no major upsets like when the company tried to split off its DVD and streaming services.

But a study from Wedbush Securities shows that 79% of U.S. subscribers still oppose any price increase. So it will be hard to boost margins even if Netflix keeps adding users.

International growth, on the other hand, is a make-or-break opportunity for Netflix to bring more money in the door. In the third quarter, 42% of Netflix's total marketing costs went to international streaming -- and it appears to be starting to pay off. “Starting to” being the operative term there. Netflix still operates at a loss internationally because of its high marketing costs, but it’s a 20% smaller loss than in Q3 of 2012.

Analysts like Carlos Kirjner doubt that Latin American broadband infrastructure can support Netflix service for international customers there, but Netflix is also expanding to other countries, most recently the Netherlands this month.  However, average connection speeds in the Netherlands are better than in the U.S., and though Latin American average connection speeds are slower than in the U.S., they are steadily improving year-over-year. I wouldn't write off Netflix's international potential based on infrastructure until we see that the numbers don’t support it.

Where does Netflix go from here?

Long-term, I doubt Netflix will be the last man standing. If international growth is slow or doesn't catch on for some reason, the company is stuck with a saturated domestic market that's resistant to price changes as the main moneymaker. And even being able to pay the bills more easily doesn't erase the threat of a competitor making a game-changing move.

A Netflix drop might not come this year or even in the next few months, but with so many potential disruptors to the stock, I'll be staying away.

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

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