Wednesday, April 27, 2011

Should You Short Netflix?

After announcing that it would miss by between 3 and 25 cents analysts' quarterly earnings forecast of $1.18 while beating expected revenues of $767 million by 4%, Netflix (NFLX) stock lost 9% of its value Tuesday. Has Netflix peaked? If so, should you bet it will fall further?

On the surface, things look good at Netflix. For the first quarter, net income grew 95% to $60 million while sales were up 46%. But warnings about higher future costs are spooking its stock.

A closer look at Netflix's reported earnings reveals two sources of rising costs. One source of higher costs is spending on international expansion -- it wants to move beyond Canada into two new countries by 2012 and the related investment could boost its international operating losses to $70 million -- 40% higher than previously thought.

Another key cost driver is paying for the streaming rights for video. This is becoming increasingly important as Netflix shifts from mailing DVDs to online streaming. Netflix does have an advantage in its track record of using technology to give customers superior value and the shift to online streaming is due to the rising cost to consumers of mailing DVDs.

But Netflix is having a harder time getting and sustaining a competitive advantage in online streaming. So investors should consider whether Netflix financials will be squeezed by higher costs for licensing digital content even as it faces price competition from Hulu and others with more favorable access to that content.

And there are plenty of companies vying with Netflix for those rights including Coinstar (CSTR), Time Warner (TWX), Apple (AAPL), and Amazon (AMZN). Not only that, but Netflix expects Dish Network (DISH) to use the Blockbuster assets Dish is buying out of bankruptcy to launch another, Blockbuster-branded streaming-video service, which would add yet another competitor.

And these competitors could help the content providers stage a bidding war that would shift the profit on streaming video from Netflix to the suppliers. If that revenue share rises to the 60% that cable companies pay for Video on Demand or the 70% that Apple currently pays, the crimp on Netflix online streaming profits could be a disappointment for investors.

And since these competitors are keeping a lid on prices, it is unlikely that Netflix would be able to pass a cost increase on to its customers. So it may be stuck with its current $8 per month price -- despite the fact that it needs to charge $20 a month in order to afford its content in HBO's view.

Does all this profit squeezing potential mean you should borrow Netflix shares and sell them short? I would not short a stock unless I thought it had a better than 50% chance of going bankrupt in the next six to nine months. And that does not appear to be in the cards for Netflix.

Nevertheless, after rising 26,030% in the last nine years at an annual growth rate of roughly 44%, it is worth looking at whether its current P/E of 66 is justified. Its earnings are forecast to grow 43% to $6.37 in 2012. This means, Netflix now trades at a fairly pricey Price/Earnings to Growth (PEG) ratio of 1.53 (where 1.0 is reasonably valued).

This is the profile of a stock that may be over-valued but not a company on the verge of bankruptcy. In the first quarter of 2011, Netflix had $150 million in cash on its balance sheet in the first quarter -- down $45 million as it spent $192 million on its streaming content library and it has a mere $200 million in debt due in 2017.

Even though it has the potential to drop in price as investors take profits on a somewhat over-valued stock, Netflix is a terrible short candidate.


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