Show’s Over for Netflix

Earlier this week shares streaming video firm Netflix (NFLX) posted first quarter earnings that were mostly in line with estimates but shares plunged nearly 12% the next day, following the April 18 report. And unlike past, post earnings sell-offs the stock has not recovered in the ensuing days and remains near the $95 level, or some 25% below its all-time high hit last December.

Does this finally spell the end for what had been a death defying (or death inducing to short sellers) rise of over 100% in just the past year and blockbusting 1,000% increase over the past four years?

What spooked investors was the company reduced its estimate for subscriber growth at 2.5 million. The company’s projections for its second quarter net subscriber additions are far below expectations of 4 million. This was particularly troubling in that international growth, which was supposed to pick up the baton from a nearly saturated U.S. market, seems to be sputtering as it still only offers most shows in English.

Making matters worse is Netflix CEO, Reed Hastings, acknowledged increased competition has not only slowed subscriber growth but has driven up the costs of acquiring and creating content and customers. I think the overall picture painted during the conference call should break the spell that has kept investors blind of the poor economics and tough competitive position of Netflix. And given Netflix still sky high valuation I think shares of Netflix could fall another 50% over the next two years.

NFLX 042116

A River of Red Runs Through It

The profitability metrics during the most recent quarter all took a significant hit. Gross margins narrowed from 33.48% to 30.04% compared to the same period last year, operating (EBITDA) margins dropped to 56.39% from 58.15%. Operating cash flow declined to 79.45% compared to same period last year, and there was no significant movement in accruals or reserves. All this means is revenue per subscriber is declining.

NFLX Revenue per sub 4.21.16

If this trend of quarterly declines continues in a linear fashion that would forecast a net profit margin of just 16% in five years from now. Slowing topline growth and shrinking margins would and should ultimately lead to a more normalized P/E in the low 20s, compared to its current 339. Which itself is misleading in that the company really runs, at best, break even on a GAAP basis.

That may soon turn into losses. Netflix’s cumulative free cash flow burn over $3 billion over the past decade. And the burn has been accelerating in recent years.

NFLC Free Cash Flow 4.21.16

If they have not been able to make money so far, what makes investors believe they will make more money in the future in an increasingly competitive market? For how long, will the market tolerate these losses in the face of slower growth and more competition?

Proliferating Platforms

Competition seems to be multiplying faster than sequels to Fast & Furious does at the multiplex. Not only are internet behemoths such as Amazon (AMZN), Apple (AAPL) and Google (GOOGL) muscling into people’s living rooms but there is also a host of legacy networks such as CBS All Access’s and Disney (DIS) has plans to push some its content such as ESPN and Disney Channel directly to subscribers. And there are also new all digital firms such as Hulu and Crackle and other delivery devices like Roku and Sling and Outerwall’s Red Box and of course satellite services such as DishNetwork.

As a pure video streaming play, Time Warner (TWX), with HBO as its crown jewel, is probably the best comparison. HBO has nearly 140 million subscribers compared to Netflix’s current 80 million. So even assuming Netflix could add another 60 million subs over the next five years, a 75% increase which far exceeds even its own estimates, that still only implies a 15% annualized growth rate.

Incredible Shrinking Library

In past years Netflix the one significant advantage over its streaming competitors was its massive library of movies and TV shows. One of the reasons Netflix has pushed more and more into original content recently is it can no longer afford that massive catalog of licensed content as cost relative to its revenue growth.

NFLX Cost of content 4.21.16

Since January 2014, the number of titles available on Netflix in the US has shrunk by 31.7%. This was particularly pronounced in movies, where Netflix’s selection had gone down by over 2,000 titles. Amazon Prime Video now has library of movies and TV shows nearly 3 times size of Netflix.

NFLX Library 4.21.16

I actually still get DVD’s in the mail in those red envelopes because hardly any of the independent or foreign films are available for streaming. And for newer, special effects laden movies I like the quality of Blu-ray. I may not be the typical customer but I think this speaks to the fact people will go where the content is; and in this regard Netflix is simply one of many platforms with no real competitive moat.

All told the picture looks bleak. I want to establish a long term bearish position. I’m buying some a LEAP put options. Specifically;

Buy the January 2017 puts with an 80 strike for $7.00 per contract.

My expectation is for shares to be below $50 within the next 18 months. This would give the puts a minimum value of $30 for a $23 or 320% gain.

Fade to black.

— Steve Smith

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About the Author: Steve Smith