The case for shorting Netflix

One firm has been killed on its short position, but it's sticking to its guns.

By Kim Peterson Dec 17, 2010 2:48PM
Credit: (© Paul Sakuma/AP)
Caption: Netflix DVDNetflix (NFLX) has some dedicated bears, and fund manager Whitney Tilson is one of them. So far, shorting Netflix has been a disaster of an investment strategy for Tilson -- check out the one-year chart below -- but he's sticking with it.

Tilson, the founder of investment firm T2 Partnerships, even put out a "Why we're short Netflix" presentation Thursday. You can download it here.

Netflix shares are up about 1% Friday to $183; a year ago they were at $53. "We've lost a lot of money betting against Netflix, which is currently our largest bearish bet," the presentation notes. Here are the main reasons Tilson continues to short the stock: 

The valuation is extreme. It trades at about 67.4 times trailing EPS, T2 notes, and 46.7 times the analyst consensus EPS for 2011. It's also at 4.6 times sales. "In short, the stock is priced for perfection and any misstep would likely trigger a huge selloff," the note says.

Netflix is at the end of its run, not the beginning. Its core business model -- the by-mail rental of DVDs -- is shrinking rapidly, T2 notes. The company has turned to streaming video to compensate for that and recently unveiled an $8-per-month plan that offers unlimited streaming and no DVD rentals. Post continues after video:
New competitors.
Netflix was able to kick Blockbuster's butt handily, but on the streaming front, the company now competes with serious rivals like Apple (AAPL), Google (GOOG), Amazon (AMZN), Disney (DIS), News Corp. (NWS), all the cable companies and the Coinstar (CSTR)-run Redbox.

That fierce competition will likely result in slower growth and a contraction in Netflix's margins, T2 notes.

Content costs going up. Netflix got a screaming deal with some of its content in the early days of streaming. But the studios have gotten wise and are also increasingly wary of Netflix. As a result, it's almost a guarantee that they're going to try to soak Netflix for future content.

T2 notes that at a recent lunch, NBC honcho Jeff Zucker was asked about licensing the network's content to Netflix. Zucker replied, "We'd be happy to -- for a lot of money!"

Netflix's library is weak. As a near-daily Netflix streaming user, I can confirm that the streaming library isn't the best. The movies are old. You can't get current seasons of many television shows. There just isn't a whole lot that grabs me, but my 3-year-old loves all the old Nickelodeon shows in the library.

T2 says there's more to like on iTunes, Amazon and streaming cable offerings. That leads to three choices for Netflix: maintain a weak library and low subscription prices, license better content and raise prices, or license better content and eat the cost. "None of these options are consistent with a stock trading at nearly 70x earnings," T2 writes.

Netflix is sealing some new content deals, but those cost big bucks, T2 writes.

There's much more in the report. I think T2 makes some fine points, but it underestimates Netflix's survival skills in its new role as content acquirer and digital distributor. On that end, Netflix will surprise its critics again and again.

But yes, the valuation is extremely high. It's too risky to short the stock, but I wouldn't buy it anytime soon.

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