3 Reasons Netflix Bears Are Wrong

When it comes to competitive strengths, profitability, and valuation, Netflix bears could be making a very expensive mistake.

Jan 26, 2014 at 10:11PM

Netflix (NASDAQ:NFLX) has traditionally been a notable target among short-sellers. Even if the bears have been running for cover lately, the stock still carries a relatively high short interest ratio of around 10%. But shorting Netflix has been a losing proposition over the last years, and the way things are going, it could also be a very expensive mistake on a forward-looking basis.

Competitive strengths
One of the most popular arguments among Netflix short-sellers is that the company lacks the competitive strengths to succeed in the long term. Amazon.com (NASDAQ:AMZN) is usually seen as the most challenging competitor for Netflix over the coming years.

Amazon Prime offers free two-day shipping, access to the Kindle Owners' Lending Library, and more than 40,000 tittles available for streaming via its Prime Instant online video service for a conveniently low price of $79 per year. The service now has "tens of millions" of members, according to the company, and it gained more than 1 million new members in the third week of December alone, so it continues growing at full speed.

Considering Amazon´s deep pockets and competitive drive, the online retailer is certainly a risk to watch, but there is no reason to believe Amazon will necessarily derail Netflix from its long-term growth trajectory. Netflix has had remarkable success in building its library with plenty of high-quality exclusive content, and that´s a crucial competitive advantage for the company. Popular names like Arrested Development, House of Cards, and Orange Is the New Black represent big differentiating factors for Netflix versus the competition.

The company has more than 44 million total members, and growth in the U.S. is not only remarkably strong but also accelerating. Netflix added 2.33 million U.S subscribers in the fourth quarter of 2013 versus 2.05 million net additions in the same quarter of 2012. In international markets, Netflix is barely taking its first steps, so the company has enormous room for growth over the years to come.

Customers are speaking with their wallets, and they seem to think there are many strong reasons for subscribing to Netflix. From a competitive point of view, the company looks healthier than ever.

Profitability
Content is expensive, and many Netflix bears claim that elevated content costs will make the company's business hopelessly unprofitable over time. However, that doesn't seem to be the case, judging by the financial figures.

Contribution margin in the U.S. increased by 420 basis points in the last quarter to 23.4%, as Netflix is increasing its membership revenues at a faster rate than content costs. Margins have been consistently rising over recent quarters, and management estimates that it will reach the company's goal of a 30% contribution margin by 2015.

Netflix is also thinking about broadening its commercial strategy by offering different kinds of streaming services for different prices. Provided the company doesn't make a really big mistake by infuriating customers as it did with the Qwikster episode, offering different alternatives for users with their own needs and income levels sounds like the right thing to do in order to maximize income and keep its customers happy.

A more efficient pricing policy could increase revenues without affecting content costs, so this could have a positive impact on profitability levels.

Valuation
Netflix trades at an aggressively high forward P/E ratio of 55 times earnings estimates for 2015. This is certainly a demanding valuation that makes the stock vulnerable to any disappointment. On the other hand, an extraordinary growth story like Netflix doesn't need to trade at a cheap valuation level.

Many of the most successful growth companies in the market have consistently traded at what could be considered "expensive" valuations over the years, or even decades, as investors continue paying above-average prices for their superior growth potential.

Some investors prefer to stay away from these kinds of companies and gravitate toward a more value-oriented philosophy. There is absolutely nothing wrong with that approach as long as it fits your own investment strategy and risk tolerance.

On the other hand, shorting Netflix solely because it looks overvalued means ignoring that future growth opportunities are a big component of a company's fundamental value, and Netflix offers some truly outstanding growth potential.

Bottom line
When it comes to areas like competitive advantages and profitability, Netflix is moving in the right direction and looking stronger by the day. Valuation is always a source of risk, but hardly enough reason to take a short position in such an extraordinary growth company. Shorting Netflix has been an expensive mistake in the past, and there is really no reason to believe things will get better for the bears in the coming years.

Meanwhile, back in your living room ...
You know cable's going away. But do you know how to profit? There's $2.2 trillion out there to be had. Currently, cable grabs a big piece of it. That won't last. And when cable falters, three companies are poised to benefit. Click here for their names. Hint: They're not Netflix, Google, and Apple.


Fool contributor Andrés Cardenal owns shares of Amazon.com, Apple, Google, and Netflix. The Motley Fool recommends and owns shares of Amazon.com, Apple, Google, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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