Shorting Netflix NFLX

I just shorted Netflix, NFLX around $178.50 a share. I have been watching and doing sporadic work on this name for the past month or so. Its been an insane stock to watch. In case you missed it, this traded at just under $50 a share last January, and has gone hyperbolic if you will, reaching a high of $209 a share just last November.


My opinion is that this stock is outrageously overvalued by almost any metric or stretch of the imagination. At $180 a share, its trading at 68x trailing twelve month earnings (TTM earnings), and on a forward basis, is trading at 46x (ie its P/E ratio). On a TTM cash earnings basis, my preferred method of looking at stocks, its a 0.33% FCF yield. Not 33%. 0.33%, less than 1%. I think I can make more with a one year bank CD, but more on that later.


So, to back up for a second, lets discuss the business. Netflix is a very popular DVD by mail rental company. They essentially killed the Blockbuster retail model of distributing rental movies. They have 280 or so distribution centers around the US, so that most of the time you can order a movie online and receive it the next day. You mail it back, pay $16 a month for 3 DVDs at a time, and really its quite brilliant. They reached profitability in 2003, and as you can guess, improved margins as they added subscribers. Its a business model that benefits from economies of scale, and they have gone from a couple million subscribers, to today they have 18mm subscribers.



On a margin basis, between 2005 and 2008 they consisently did 5-6% net income margins. Revenue grew quite nicely from $272mm in 2003 to $1.4BB by year end 2008. Then, their business model evolved. They got into the online business of streaming TV shows & movies. This is different than what Amazon, iTunes are doing, which is offering online movie download rentals. Download time is too long for many people, and at $5 / rental on iTunes, too expensive too. So Netflix came in and offered a deal whereby for $8 a month, you can stream unlimited TV/movie content from their online library. You might have heard of Hulu, which streams TV online, but its an advertising based model that is free.



So, Netflix rolled out its streaming service in 2008, and its been wildly successful. Here's why. To get streaming content, Netflix went to Epix (which owns Paramount, MGM, Lionsgate) and paid them something like $25mm a year fixed for all of their movie content. Then they did the same with Starz paying them something like $30mm a year for all of their titles. Together that got them a good library of movie titles. I believe the company's website lists 2,000 movies available for streaming, and then they have 100,000 in their movie DVD library in total.



Basically it was a major coup, and the guys who cut the deals at Starz and Epix now look like idiots. They didnt realize that movie streaming would be so popular, nor did they realize that this might cut into their market with the cable companies. But now the cat is out of the bag. When the original Epix deal expired last September 1st, they cut a new deal. I could not find the price tag, but reports are that it will cost Netflix $1BB over the next 5 years. Yes, thats a BILLION DOLLARS for 5 yrs, or about $200mm per year. Far higher than the $25mm they paid prior.



The same thing will happen when the Starz contract comes due October 1st of 2011. That deal is $30mm/ year now. Estimates are that it will go to $300mm PER YEAR, up 10 fold.


So what happened to earnings in Q3 with only one month of the new Epix deal? EPS fell from 80c in the June quarter, to 70c in the September quarter. Net income margins which looked great under the prior deals, fell from 8.5% in Q2 2010, to 6.9% in Q3 2010. And that is one month with the new Epix deal.


As for Q4, the company already guided to a very wide range of earnings, from 59c to 74c a share. Recall they did 70c in Q3. Either way, that is a range of margins between 5.5% and 6.7%, still going down.


Now the problem here and the problem with the short is cash vs accrual accounting. You will always hear me refer to CASH based earnings. Cash is all that really matters (unless you like your earnings of the Enron variety, faked). I noted that while Q3 earnings were not great, declining margins, EPS down sequentially, I also noted that D&A didnt change much. However, Capex spending DID. That is, cash went out the door to fund the Epix deal, and yet they havent really starting amortizing it into earnings. (and yet earnings still declined).


So, generally to get to cash earnings, I compare D&A and cash capex spending over time. Netflix has posted D&A of $73mm in Q1, 75mm in Q2, and 86mm in Q3 this year. Capex which should track it reasonably closely, has changed from $101mm in Q1, $92mm in Q2, and $149mm in Q3. So in total they have cash costs of $109mm, that they have YET TO EXPENSE compared to D&A. (ie, total capex less D&A is $109mm).


Well, you should guess that this $109mm of additional capex (movie content mostly), will have to get expensed. D&A will rise next year, and cash costs are going way up (with a new Starz deal). For a company that did a total of $145mm in Net Income in the last 12 months, $109mm of D&A expenses waiting to roll into the Income Statement is a LOT. Hence cash earnings are much lower than real earnings here.


My math is they did $0.60 in CASH EPS in the TTM period, vs reported earnings of $2.65. And with the Starz deal next year hitting them the same way, my basic belief is that they are turning more into a cable company. Yes, Netflix got a 2 year free bye from some major movie programmers to get cheap content and deserves a lot of credit for it. But this business model is very very unsustainable. Costs are going to rise another $270mm per year starting this October probably as the Starz contract is renegotiated too.


Net net, with both new contracts, I calculate EPS will at best be $2.70 per share. That is, you are paying $9.7BB for a company that will do around $150mm in Net income. Thats 67x earnings.


Admittedly I might be early with the short. They might depreciate these cash outlays on a more back end loaded basis. And, since Starz doesnt roll off until next October 1st, earnings until after that date will look decent.


Another item with this stock is internet usage. That is, consumers are in many cases using CABLE company internet service in many cases to get streamed movies/TV, that is Cable type service. The Cable guys dont like this clearly. Some estimates are that Netflix streaming accounts for 20% of all internet traffic in the evening. Networks are getting strained, and there is a high likelihood that within a year or two, Internet Service Providers (ISPs) will start rolling out tiered pricing. Cisco (I like that stock) predicts internet traffic will triple by 2014. Tiered pricing will mean that the $8/ month model cannot continue. Programming costs will have to get passed on to subscribers, and perhaps their internet usage fees will go up as well. ISPs will put up with only so much free riding, especially to the extent that it eats away at their own business (cable co's).


Net net though, I finally assumed that the downside to this stock is that margins stay flat at 7% (although I think they'll normalize at 5-6%). Further I assume that over the next 3 years, they grow 30% per year. That would take the company from 18mm subscribers today to 37mm by 2014. To put that in perspective, there are 99mm total cable/satellite subscribers in the US, and 73mm homes in the US with internet service AND a DVD player. 37mm subs would be over 50% market share of the available market, which is just enormous, and not terribly likely. I am quite sure AOL, Amazon, Apple, and a dozen other big smart companies are going to figure out a way to stream movies over the internet. Barriers to entry are not high. Nobody has this kind of market share.


But even if they achieve this, at 7% Net margins, the company would be generating about $6.25 in EPS. And at $180 per share, still equates to a very high P/E multiple of 29x. Wow, even today, Apple trades at 15x, GOOG trades at 18x, and mature cable companies like TWC around 15x. I estimate that this stock could trade within a range of $240 down to $75. Its hard to guess an upper limit, because irrational stocks like this can continue to trade irrationally. However, I personally would value this stock at 30x 2011 earnings at most, which is around $95, using a more reasonable $3.15 in EPS for 2011. (vs the Street at $3.86 in EPS).


There isnt accounting fraud here, but unrealized expenses on the balance sheet are going to come back to haunt them. Management is very solid here. Their marketing is phenomenal, by all accounts people LOVE their service. The CEO it should be noted though, has sold piles of stock. I couldn't even add it all up, it was many many 10,000+ share blocks every single month last year. He's a smart guy, he knows when to sell too.