Netflix stock is too risky after big run

Despite a recent rebound and high-profile Icahn stake, the all-or-nothing growth plan for NFLX should make new money leery.

By InvestorPlace Dec 5, 2012 10:42AM

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image100 CorbisBy Jeff Reeves

 

Netflix (NFLX) has surged roughly 50% since Oct. 1 thanks to a flurry of big news items. The most recent came yesterday with a huge Disney (DIS) content deal that involves classics like "Dumbo" and "Pocahontas" along with new releases starting in 2016. Netflix stock popped about 7% as a result.

 

But before buying into this streaming video stock's rally, take a deep breath and press pause.

 

First, on the Netflix Disney programming deal since it's so recent: I think it's a net positive, but hardly a game changer. As a parent who watches NFLX regularly with the kids, Disney content will be a welcome thing in my household. But it's a bit like preaching to the converted because I was already won over by the depth of children's content and the "kids only" interface I can use on my Wii. The trouble with programming seems to be a common complaint that movies and TV shows are stale -- and I don't see how a 1941 flick like "Dumbo" changes that dynamic. (I opined more about the deal here.)

 

The bigger story for Netflix seems to be long-term -- specifically, a high-risk, high-stakes state of affairs at Netflix right now. And if things sour, new money could be making the very painful mistake of buying a top.

 

First, let's rehash why there has been so much recent optimism beyond just the Netflix-Disney deal:

  • Very satisfied customers: In early October, Bloomberg reported on a Citigroup note showed customer satisfaction is clearly on the mend. Trouble with keeping subscribers happy has been persistent since the 2011 Qwikster debacle, so this was an important development, as I mentioned here.
  • Netflix earnings: The company beat profit forecasts in its earnings report, boasted 2 million more subscribers worldwide (500k in the U.S.) and a return to profitability.
  • Analyst upgrades: In October, a Morgan Stanley analyst upgraded his prediction and changed his target price to $85. Citigroup put a $120 target on NFLX.
  • Carl Icahn: The activist investor took a 10% stage in Netflix at the end of November, as InvestorPlace reported here.

All fairly bullish signs, to be sure. But to me, a 50% pop seems to indicate that these developments have already been priced in -- and worse, that they raise expectations even more for an already high-stakes 2013.

 

That leaves no room for error. So before you consider buying NFLX, take a look at these risks before you settle in with your popcorn:

 

A nosebleed P/E. Netflix is barely break-even in 2012 and analysts projected a mere 49 cents in earnings for fiscal 2013, giving Netflix stock a forward price-to-earnings ratio of more than 160, higher than even Amazon.com (AMZN)! Amazon has been getting away with that valuation despite razor-thin margins and a massive reinvestment in R&D for its Kindle. Do you really think Netflix and Reed Hastings are in the same league as Amazon and Jeff Bezos -- especially after the CEO's half-assed Qwikster apology in 2011? I sure don't.

 

International growth, but no profits. Sure, Netflix continues to add international users. But the profits remain elusive. International streaming operations posted a net loss of about $100 million in 2011 … but are posting losses of almost $100 million a quarter in 2012! Sure, Netflix is adding about 500,000 users or so a quarter around the globe -- it tallied 687,000 quarter-over-quarter growth in the third quarter on top of the 559,000 added in the second quarter -- but you have to wonder when it will reach the scale to move into the black.

 

It's all spent on content. Content costs continue to spiral upward. The financials provided by Netflix show that cash flow spent on "additions to streaming content library" went from $406 million in 2010 to $2.3 billion in 2011. As for 2012, NFLX has already tallied $1.9 billion in streaming content costs through the third quarter, so that number is likely to move up again. So gains from subscriber and revenue growth continue to be plowed into the cost for streaming video rights as fast as they are added to the balance sheet. Makes you wonder when profits will materialize -- and even worse, what will happen if subscriber growth stalls.

 

Original programming is untested. Netflix made a big $100 million deal with director David Fincher this spring for two seasons of a political drama called "House of Cards" that hits the service on Feb. 1, 2013, according to The Daily Beast. Elsewhere, the 2013 schedule includes the rollout of monster-mystery "Hemlock Grove," a second season of Euro-gangster series "Lilyhammer," the women's prison drama "Orange is the New Black," comedian Ricky Gervais' "Derek" and a relaunch of the cult sitcom "Arrested Development." The logic is sound -- original programming is cheaper than streaming rights. But only if the programs catch on. Those banking on the future of Netflix are taking a big risk on these shows before actually seeing a single episode.

 

Margins evaporating. DVD subscriptions continue to decline, as expected, but margins are leaving with them. The domestic DVD biz yielded a hefty 48.2% margin in the third quarter. Streaming? Domestic margins are 16.4% That means Netflix needs three streaming customers to make the same profit it did off of just one DVD subscriber.

 

Oh yeah, competition. And here is where the math simply because too much to bear.

Miriam Gottfried of The Wall Street Journal had an article on Netflix that had a very cutting set of statistics. She writes that "Mr. Hastings has said 60 million to 90 million U.S. streaming subscribers are achievable. The company had 25.1 million domestic streaming subscribers at the end of the third quarter. Trouble is, there are just 81 million broadband households in the U.S., according to Sanford C. Bernstein."


As if the simple ceiling of 81 million wasn't enough, consider Netflix faces stiff competition from the likes of Hulu and Amazon and even cable providers like Comcast (CMCSA) that offer on-demand Web streaming to customers now.

 

In other words, Netflix is still growing ... but not making any money. And thanks to lower margins on streaming and higher costs for new content, it must continue to grow at a decent clip simply to tread water. Eventually Netflix will reach critical mass where the growth will slow and expenses will not -- and that tipping point is going to be very painful for investors.

 

That's not to say Netflix can't succeed. If its original content and international growth get traction and it fends off competition, the gains could stick and shares may even drift higher. But investors need to be realistic about the risks here.

 

Personally, I think the bar is awfully high, especially after the recent pop on good news and short-covering. Maybe the company will find its way to turn significant revenue growth into significant profit growth by 2014 ... but the downside will be quite severe if it doesn't. And the upside doesn't seem impressive given the tough competition from entrenched names coupled with ultra-low margins in the space.

 

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Jeff Reeves is the editor of InvestorPlace.com and the author of "The Frugal Investor's Guide to Finding Great Stocks." Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.

 

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