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The 1 Tech Stock I'd Never Put in an IRA

By Leo Sun – Oct 25, 2016 at 8:42PM

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Netflix is an exciting stock to watch, but it’s not the ideal investment for your IRA.

Investors can add a dizzying array of investments -- including stocks, ETFs, bonds, CDs, and mutual funds -- to an individual retirement account or IRA. Many financial advisors will tell you to put conservative, income-generating stocks into an IRA to take advantage of the compounding effects of reinvested dividends.

Image source: Getty Images.

However, younger investors might consider adding a few riskier stocks for their IRAs -- since some promising plays could become multibaggers over several decades. But there's a fine line between "risky" stocks with high multiples and "cult" stocks that are propped up by the their brand recognition instead of fundamental growth. One such cult stock -- which I personally would never put in an IRA -- is Netflix (NFLX -0.22%).

Why Netflix might seem like a good choice

Many investors might think Netflix is a sound long-term investment because it's the most popular OTT (over the top) video service in the U.S., and its brand has become synonymous with streaming video.

Plenty of numbers indicate that Netflix's growth is accelerating. Total paid memberships rose 26% annually to 83.3 million last quarter, international paid subscribers surged 68% to 40.2 million, and its total revenue rose 36% to $2.16 billion. Analysts expect Netflix's revenue to rise 30% this year, compared to 23% growth in 2015.

Rival cable networks and streaming services have struggled to match the critical acclaim of Netflix's original content, like the Emmy-winning House of Cards. If cord-cutters continue to abandon traditional pay TV platforms for OTT ones, Netflix's double-digit sales growth could go on for years to come.

Image source: Netflix.

But why Netflix isn't built to last

That long-term outlook looks rosy, but it doesn't address the three most serious headwinds for the company: high expenses, thin margins, and dangerous competitors. Netflix only started producing original content because the licensing costs for TV shows and movies from other companies were too high. Last quarter, Netflix's streaming content obligations (the amount it promises to pay studios to license future content) rose 38% annually to $14.4 billion.

However, Netflix's original programs aren't cheap -- Marco Polo's first season reportedly cost a whopping $90 million to produce, while the first two seasons of House of Cards cost around $100 million. Since Netflix only generates revenue through monthly subscription fees, it pulls off a delicate balancing act off offsetting content licensing fees and the production costs of original shows with "acceptable" membership fees.

But raising fees could get tougher due to rising competition, particularly from (AMZN -0.09%), which bundles its Netflix-like Amazon Video into its $99-per-year Prime service. Earlier this year, Amazon started offering a stand-alone Amazon Video plan for $8.99 per month to undercut Netflix's price hike from $8.99 to $9.99.

Image source: Netflix.

Unlike Netflix, Amazon can leverage Amazon Video as a loss leader to tether more members to its ecosystem, since Amazon can offset those losses with higher-margin businesses like AWS.

Amazon is applying that same strategy to other overseas markets (like Japan) where it has a solid e-commerce foundation that can be tethered to Prime. If Amazon starts to offer more popular shows than Netflix at lower prices, the latter's impressive growth could grind to a halt.

Weigh the company, don't just vote for it

Benjamin Graham once famously said that "in the short run, the market is a voting machine; but in the long run, it is a weighing machine." By "weight," Graham meant bottom-line growth -- a glaring weak spot for Netflix.

Netflix generated just $106 million in operating income last quarter, which gives it an operating margin of just 4.7%. Its net income came in at $52 million, which represents a net profit margin of 2.4%. If competition heats up, Netflix may struggle to stay in the black as it tries to match its rivals' membership fees and higher budget content. That's why Netflix's net earnings fell 53% last year.

Netflix currently trades at 344 times earnings, which is very pricey relative to its earnings growth and the industry average of 40 for pay TV providers. This indicates that its stock price is supported by the love for its brand instead of its long-term earnings growth potential. That also means that once the market falls out of love with Netflix, it could fall very quickly without a reasonable multiple or dividend to limit the stock's downside.

The key takeaway

Netflix isn't a terrible investment. But I wouldn't place it in an IRA, which is designed to house long-term investments for decades. For now, I simply don't see a clear way for Netflix to grow its margins and profits over the long term, unless it diversifies away from the low-margin business of streaming media. Without sustainable profit growth, Netflix could fail to make the transition from being a stock investors "vote for" into one that they can actually "weigh."

Leo Sun owns shares of The Motley Fool owns shares of and recommends and Netflix. 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 has a disclosure policy.

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