July 22, 2015

Here's why Netflix could be a SELL from here

I don't have a dog in the Netflix hunt. However, if I was fortunate to have owned Netflix going into the quarterly earnings report Wednesday evening, I would consider selling it today.

The narrative below is not intended to be a comprehensive analysis of the company, but rather is meant to point out some general issues facing Netflix and its investors over the next few years that currently may be ignored and, to me, are sufficient reasons to sell the stock.

On a split-adjusted basis, Netflix's shares have risen from $7 a share to $116.40 a share over the last three years.

On Thursday alone, when the stock rose by nearly $18 a share, Netflix's capitalization grew by almost $8 billion, to almost $50 billion. As a means of comparison, the market cap of Sony Corporation  (SNE - Get Report) is only $33 billion and the market cap of Yahoo  (YHOO - Get Report) is $13 billion under that of Netflix. Netflix's market cap is now nearly one-third that of Comcast  (CMCSA - Get Report), only $20 billion less than the $69 billion capitalization of Twenty-First Century Fox  (FOX - Get Report) and is within $25 billion of Time Warner  (TWX - Get Report).

In premarket trading Friday morning, Netflix's shares gained another $2 to nearly $118 a share.

Clearly the bulls are stampeding based on a subscriber count, both in the U.S. and outside of the U.S., coming in far better than consensus expectations.

Driving the better sub count is a currently great content offering by the company. But, absent from the dialogue -- perhaps because many NFLX bulls are Internet analysts and not entertainment analysts -- are the following factors:

  -  The profitability of new subscriber additions represents a fundamental question in valuing Netflix. Most of the excitement surrounding the company is the size and current low penetration of the addressable market. Netflix's strategy is to sacrifice profit over the next few years in order to generate substantial sub growth. But, this begs the question of how much profit will be achieved by generating additional subs. Thinking about the lower profit in terms of a customer acquisition cost compared to the value of the customer acquired would suggest this may not be a very good business decision.

   - Content is expensive and costs are escalating -- to an estimated $5 billion in 2016. The company does not offer estimates of the cost of self-produced content.

   - No ratings for the consumption of Netflix content are available. To be blunt, most of the content enthusiasm is generated by analysts who have some affiliation with investment banking. It is clear that Netflix's "House of Cards" is wonderful -- but is it $8 billion wonderful?

   - Not all self-produced content makes it. That is part of the explanation why content producers sell at only 10-15x EBITDA. Forgotten by the Netflix bulls is that a self-generated production such as "Marco Polo" costs more than $100 million. It has been reported that a second season has been ordered; we shall see about that!

  -  Consensus earnings estimates have tumbled. First- and second-quarter reported earnings have failed to meet expectations and analysts' earnings per share forecasts have been slashed for 2015-2017. Consensus 2016 EPS is nearly 50% lower than projections by analysts as recently as 90 days ago.

  -  Valuation is rich -- maybe beyond so! The shares trade at nearly 150x reduced estimates projected for next year as the company spends to grow subs.

Summary

The investment case for Netflix continues to be pushed out into the future as profitability and cash flows have consistently disappointed.

Investors appear increasingly willing to judge the company not on traditional metrics of earnings, but rather on how much Netflix is willing to spend.

As Greenlight's Einhorn has further remarked, in all likelihood the success of the company's spending spree will not be known within the investment time horizon of many of the traders and investors who are involved in the shares today.

I might very well be early in the view I have expressed this morning, and/or it might take higher interest rates or some other factors to end the current infatuation with tomorrow in Netflix.

It's a lonely feeling not owning Netflix -- but it was mighty lonely, too, being negative in early 2000 on the Internet stocks.

I would also add that with the benefit of hindsight, the exceptionally smart investor Carl Icahn recently sold out too early in Netflix -- but in the fullness of time his decision might prove to be very wise.

From my perch, investors in Netflix are again partying like it is 1999-2000. But, history usually rhymes and investors have forgotten the pain inflicted in the euphoria of 15 years ago.

Sell Netflix.
Position: None 

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