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.
