You're Crazy to Short Netflix

Check your favorite CEO's holiday card list, and chances are you won't find short sellers' names on it. That's understandable; they're natural adversaries. Short-side investors win when managers lose.

Many of these short sellers are vocal. Think of them as front-row hecklers at a basketball game, yelling at the ref. You just know the zebra would love nothing better than to toss these jackwagons, the same way he'd kick out a coach for arguing fouls.

So it's at least a little surprising to see Netflix (Nasdaq: NFLX  ) chief executive Reed Hastings trying to save one of the people who's shorting his stock from realizing losses.

You've been warned, shorty
Earlier today, Hastings posted an open letter to well-known investor Whitney Tilson, in which he implored the former Fool columnist to cover his funds' Netflix short position. (Find Tilson's short thesis here.)

Hastings' counterargument describes Netflix's various advantages, including a rising subscriber base, a large and growing digital library, and low-cost streaming delivery support from partners such as Akamai Technologies (Nasdaq: AKAM  ) and Level 3 Networks (Nasdaq: LVLT  ) .

"The core competitive barrier for direct competitors is brand/subscriber-evangelism," Hastings writes. "Our large subscriber base is very happy with Netflix, and tells their friends about Netflix. That means that the cost of acquiring the incremental [1 million] subscribers is lower for us than for a competitor, and thus our net additions are higher. There are also lots of other smaller competitive barriers, but the happy subscriber base is the big one."

Essentially, he's saying that Netflix is too well-positioned to reward a short seller. I think he's right, but that's not why I would avoid shorting Netflix. Instead, the numbers scare me:

Metrics

2006

2007

2008

2009

Average normalized P/E 108.5 27.3 28.8 28.9
Normalized earnings growth 386.2% 29.2% 24.3% 46.9%
Return on capital 12.7% 12% 17.8% 28.8%

Source: Capital IQ, a division of Standard & Poor's.

Netflix has earned its premium valuation and then some. Normalized earnings have grown faster than the average multiple in three of the past four years. Returns on capital have more than doubled over the same period.

More importantly, Netflix operates in rarefied air. Only 53 companies trading on U.S. exchanges and worth at least $250 million in market cap have produced better-than-40% normalized net income and 25% returns on capital over the past year. Netflix is one. Others include InterDigital (Nasdaq: IDCC  ) and Yongye International (Nasdaq: YONG  ) . Of Netflix's primary competitors, only Apple (Nasdaq: AAPL  ) makes the list.

Netflix Earnings History

FY 2006

FY 2007

FY 2008

FY 2009

Consensus earnings estimate $0.51 $0.68 $1.25 $1.71
Actual EPS $0.70 $0.94 $1.34 $1.99
DIFFERENCE (%) +37.3% +38.2% +7.2% +16.4%

Source: Earnings.com.

There's also history to consider. As the above table shows, Netflix has routinely crushed Wall Street estimates over the past four years. A $0.01 miss in the third quarter is the first such miss since the first quarter of 2007, according to Earnings.com data. My point? Netflix has a history of surprising skeptics, or what David and Tom Gardner called an "open-ended opportunity" in the Motley Fool Investment Guide.

Surely, the good times can't last forever. But making a big-money bet that they'll end soon strikes me as too dangerous -- and entirely unjustified, going by most of the numbers.

Now it's your turn to weigh in. Would you short Netflix right now? Please vote in the poll below, and then leave a comment to explain your thinking.

Interested in more info on the stocks mentioned in this story? Add Netflix, Akamai, Level 3, Yongye, InterDigital, or Apple to your watchlist. 

Apple, InterDigital, and Netflix are Motley Fool Stock Advisor selections. Akamai is a Motley Fool Rule Breakers recommendation. Yongye International is a Motley Fool Global Gains pick. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Tim Beyers is a member of the Rule Breakers stock-picking team. He had stock and options positions in Apple and a stock position in Akamai at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. You can also get his insights delivered directly to your RSS reader. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool owns shares of Apple and Yongye International and is also on Twitter as @TheMotleyFool. Its disclosure policy is short poor disclosure.


Read/Post Comments (8) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 20, 2010, at 8:25 PM, pillback wrote:

    Nice article, I do not have a position in this stock right now, and agree that the shorts have been pounded in the past. The short term future may be bright, but the 1-3 years forecast will be dark and painful.

    Netflix Pros:

    Netflix is currently the leader in steaming online media content. They have a huge advantage because they are not only a first mover in the industry, but also have accumulated a large subscriber list. Other than this, I can't find one other positive thing to say about the company.

    Netflix Cons:

    1.) Insider Selling. By November 4th, Netflix Chief Financial Officer Barry McCarthy dumped just under 100,000 share equivalents. He sold 91,181 shares between $200.36 and $201.11. This was over 60% of his stake in the company leaving him with just 51,563 shares of NFLX stock. He then announced his retirement from the company citing vague reasons for leaving. If the CFO is leaving after dumping his majority stake in the company, this should have all shareholders extremely suspicious. Why would any CEO leave if "supposedly" this company is still in the early stages of its growth cycle.

    2.) Netflix leases their content. Whenever a company has to lease content, they are never guaranteed the same price. With movie and TV companies loosing DVD sales in order to allow NFLX to stream their content, eventually, these losses will be passed onto NFLX and there customers. When this happens, their margins will become so compressed, that it will be almost impossible for them to continue operating.

    3.) Increased competition. Ever heard of AAPL or AMZN? AAPL and AMZN are already able to sell the majority of the content that is found on NFLX. How much longer do you suppose it will take AMZN or AAPL to tap into this market? It is not as if we are talking about two new companies here. AMZN and AAPL are two major retailers that people already use on a daily basis and both have a larger market cap than NFLX. If either AMZN or AAPL decided to enter this market, NFLX would have to lower prices in order to compete, which once again, would crush margins.

    4.) Cryptic Conference Calls. Listen to the last two conference calls when the CEO is asked about where gross margins will be in the future. After you get dizzy from listening to the CEO talk in circles, consider why there is no real answer given.

    5.) Ummmmmmm.... Valuation maybe? Ok, even if you disagree with any of my other reasons, which are sound proof for declining prospects of growth, I will site valuation. P/E close to 70? Really? This multiple is based solely on "possible" projected growth with no real proof that it can continue.

    This company is a FAD, nothing more.

    I am not short NFLX right now. However if it breaks 200 again, I will short the hell out of it because this ship is sinking.

  • Report this Comment On December 20, 2010, at 9:12 PM, FASTERFREDY wrote:

    try watching a movie on your Iphone while driving to work. ALLSTATE, would cancel your insurance!!!, while I have been a netflix sucriber for a few years now, since I canclwed the cable/Comcast, rates climbing ,climbing, you get the picture yet? last year the Wife sugfgested we buy some of the stock!. It was around 58.00 per.share,I said why, that seems expensive! well I did some reasurch, and WALLA! this seemed interesting. So I bought 50. then aftter 2010 ,began , i bought more, and then some more. my broker said , are you NUT's!!! MY reply, NO , check mit out. Now its a year later , and i'm $45.000,richer! . I might t5ake some off the table, wait for these short sellers drop it down some , &

  • Report this Comment On December 21, 2010, at 11:32 AM, orangefloyd wrote:

    @pillback:

    Your cons list is sometimes compelling, sometimes misguided.

    1) Definitely a red flag... but not a smoking gun.

    2) Too much uncertainty here to predict anything. Your scenario is one possible outcome, but far from guaranteed. We've seen studios put the squeeze on Netflix with regards to release dates, but the reaction has been just a big shoulder shrug. Netflix has more power here than you might think.

    3) Both Amazon and Apple are already in the market, albeit sharing a strategy that differs from Netflix's. Even if they change tactics and use a subscription model like Netflix's, take a look at Apple's grip on the music market to see just how difficult it can be to topple the entrenched leader even by companies such as Amazon and Microsoft. Amazon, Apple, and other competitors will need to do a lot more than simply show up to put the squeeze on Netflix.

    4) Red flag. Haven't heard the calls to say how legit your interpretation is of them, however.

    5) Typical for a story stock. Makes it scary as hell, but not a red flag in and of itself.

    The *company* is not a fad. The *stock* may be a fad. If you think the company itself is a fad, it is telling of your lack of understanding for this type of business.

    The hallmark of a story stock is that high expectations have been priced into the stock, so any minor uncertainty could prove disastrous if it goes the wrong way. There's plenty to be scared about, but you'd better feel the fear regardless of whether you go long or short. If this stock doesn't raise any questions for you, you're not protecting yourself, and someone's going to get bit.

  • Report this Comment On December 21, 2010, at 11:34 AM, jmbring wrote:

    nice article Tim, thanks

  • Report this Comment On December 21, 2010, at 12:01 PM, macrotrader wrote:

    @pillback

    I have no position in this stock, as I missed many opportunities thinking it was overvalued for what it was too. Now I think it is even more overvalued, however I think your "assumption" that the 1-3 forecast will be dark and painful is somewhat fanciful. That said the probability of a slow down in growth is greater than 50%, but that does not equal a "cratering" of the stock.

    The main pro of the company is as a one stop visual entertainment(TV/Movie/Docum) hub. It allows me to watch what I want when I want for a good price. I personally think they could raise the price to $25 per month and still be good value(with a stronger library, which I am assuming to be the case, should the rates go up substantially). At $25, it would still be better than a premium movie channel subscription on cable. In fact has anyone analyzed a schedule to see what movies are shown in any given month on a "premium" movie channel?

    1) The man was leaving and any prudent individual does not want too much money locked out of his sight. To assume ONLY a negative connotation only confirms your bias. But I'll cede you this point..ONE rat is leaving the sinking ship.

    2)No company pays the same price for it's "cost of goods" forever. But, co company prices itself out of business either, for the content seller to make money, he needs a content buyer, unless of course he want to maintain a single channel and it's cost base.

    Declining DVD sales has nothing to with NFLX, if that argument holds then no entertainment rental company would ever survive. Anyone that wants to buy a DVD still can.

    3)AAPL and AMZN have different business models and NFLX is on AAPL's platform. AMZN IS in the business - check out AMZN VOD. Oh, and Point two would apply to any competitor also..except NFLX already has traction. Margins being crushed is only one scenario. Whats the entry barrier to create a world wide web search algorithm?

    you see anyone crushing GOOG in the next 1-3 years?

    4) I have and he is like every other CEO. Hopefully a moral compass would keep him from lying, with Sarbannes-Oxley as potential stick. He has no clue, all he can is implement his vision and see if it was as anticipated and making corrections where needed to remain on course. If you want him to give you definitive numbers, you are in the wrong game. In fact, aren't a few CEOs locked away for massaging the books so that they hit their numbers?. i would be more wary of a CEO guaranteeing me quarterly numbers.

    5) 70 what?..P/E means nothing w/o context. Is CRM overvalued at a P/E 200+?

    P/E is a linear mathematical equation. Valuation on the hand in its purest form is a non-linear exercise. Rising costs does not automatically signify a decrease in margin. That would assume elasticity on on side of the equation and inelasticity on the other.

    Google/Facebook/Twitter/AAPL were fads - even the internet was a fad at one time. I recall when i was an analyst in the mid 90s and the 2g phones were rolling out. People were talking about about reading content on their phones - and that was decried as a fad...look where we are today and the companies that stuck with it.

    Let us know how you fair when you short it above 200. I would intrigued to see how you fair.

  • Report this Comment On December 22, 2010, at 5:31 AM, quaternion2 wrote:

    So far I thought Netflix had a pesky problem to deal with as the new FCC regulation apparently favors providers like Comcast etc. Yet I argue that limiting bandwidth or charging more for it will hurt Comcast as their subscribers will defect rather than stay with them. This will make them (Comcast and others) loose both content and internet subscribers to pure internet providers whom will reckon the investment in broadband improvements worth taking. Besides, even if Netflix charges more, It offers freedom in exchange. The above argument is quite speculative, yet providers like Comcast are very unlikely to be able to turn the fate of the Internet by slowing it down. On the contrary it is easy to predict that Internet will get increasingly faster. Netflix's too good to die.

  • Report this Comment On December 22, 2010, at 11:49 AM, pstoimenov wrote:

    That is funny that Reed Hastings is saying that Netflix is dangerous for the shorts. After all he is the CEO who cashes in his options as soon as possible and does not have direct holding in his own company (last time I checked). To keep his dignity I think he needs to keep it quiet.

    I would not short NFLX despite outrages valuation, because shorting on valuation is a losers game. Markets are irrational place and NFLX is one of the most irrational stocks. Also NFLX is likely manipulated by the big institutions- they hold like 90 % of the shares and leaving the small investors to fight over the remaining few million shares pushing the share price higher. Small retail investors are suckers for this kind of fairy tales.

  • Report this Comment On December 30, 2010, at 6:37 PM, FoolSolo wrote:

    Good article. However, I have to agree with Pillback on a few points, and may disagree with him on others. While I don't think NFLX is a fad, I do think they are overvalued and their margins are a real big concern. With profit margins around 7% and a debt ratio of 1.23, I can't see how this company is going to live up to the enormous expectations currently baked into the stock valuation.

    I have had to resist the temptation to short this stock for a while, although I was really close selling puts when it was over $200. The reason I would not short NFLX is not because I believe they have great upside potential, but more because I think NFLX has momentum and a great lead in a great business idea, which will keep them elevated for a while.

    But I see multiple threats on the horizon for NFLX, including the likes of AAPL and AMZN, who have plenty of cash and resources to get over the barriers. I also think BlockBuster is still a credible threat, despite their horrible financial situation. The trouble with BB is their huge brick and mortar presence, but they are more than adequately positioned to build up their streaming capability from the paltry offering they currently have. Let's not forget, they already have capability, the contracts, and a subscriber base.

    I also see potential threats from Comcast and the Dish companies. They already have some form of on-demand capabilities, so a few tweaks with pricing and delivery could put their offerings in direct competition with NFLX.

    Finally, I also see a threat from the Network Bandwidth companies who are looking to charge higher premiums to carry the NFLX streams. Remember that thin 7% margin I mentioned above? I can easily see how that could erode significantly lower.

    I would have loved to be in NFLX at 20, 30, 50, 100. But I missed it. However, if I had it I would be rather defensive at this point, and I'd keep my finger on the trigger.

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