Yes, yet another value investor has taken the short side against the overpriced Netflix. Why will he make money? Because it’s not just the lofty valuation. The business is falling apart and Wall Street seems to just be taking notice now.
(Disclosure: been short Netflix now for 3 weeks, plan on holding for awhile)
Okay, so the first item to note is the large amounts of insider selling (look at aggregate amount of buys & sales the last year at top right):
There was more than $200 MM sold, with not a single purchase, in the last 12 months for Netflix. Netflix co-founder, Reed Hastings, seems like he was selling just about $1 MM every week. Now, it’s not always the case that insider selling means the company is headed for trouble, but it sure isn’t the greatest vote of confidence…
Next is the growth in subscribers and growth in revenues. It seems reasonable to expect more competition in the future from the likes of Amazon, DirecTV (through Blockbuster), Hulu, Megavideo & others.. I started to think that maybe the figures would be unsustainable for the growth in subscribers vs. the growth in costs. Here are the figures:
# of subscribers (and percentage that are free subscribers):
- 2005: 4,179 (3.7% are free)
- 2006: 6,316 (2.6% are free)
- 2007: 7,479 (2.0% are free)
- 2008: 9,390 (2.4% are free)
- 2009: 12,268 (3.1% are free)
- 2010: 20,010 (8.7% are free)
So, maybe Netflix is reaching a little too hard now to get additional subscribers. It’s the number they’ve always touted in annual reports- that growth rate in subscribers- that gets Wall Street very excited. However, when looking at revenue per subscriber (not even profitability), it is a little troubling:
Revenues vs. Revenues per subscriber:
- 2005: $682 MM vs. $163
- 2006: $997 MM vs. $158
- 2007: $1,205 MM vs. $161
- 2008: $1,364 MM vs. $145
- 2009: $1,670 MM vs. $136
- 2010: $2,163 MM vs. $108 (has come 50% last 5 years)
So, with a massive increase in subscribers while some getting less out of them on a per-subscriber basis, I was curious how much the increase in revenues lagged the increases in subscribers… It shows how much Wall Street has been duped into thinking subscriber growth directly translates to growth in value of the company:
Percent Increase in Subscribers vs. Percent Increase in Revenues:
- 2006: 51% vs. 46% (virtually equal)
- 2007: 18% vs. 21% (virtually equal)
- 2008: 26% vs. 13% (slight 10% differential)
- 2009: 31% vs. 22% (slight 10% differential)
- 2010: 63% vs. 30% (massive 30% differential)
Now, while the company has been growing in the double digits the past 5 years, it seems their revenues aren’t keeping up with subscriber growth & I’m not sure it’s sustainable to assume everyone’s going to keep signing onto Netflix at the same price…
Anyway, with that small seed of doubt planted in your mind, here’s the fun part- the costs and how they’ve changed in the last 5 years.
I’ve listed the forward 1-year library content costs vs. Cost of Subscriptions on Income Statement for that year. (so, for 2009, the $91 MM is an estimate from 2008 on library content costs, whereas the $909 MM is listed on the Income Statement as total subscriber costs):
- 2005: $8.7 MM vs. $394 MM (2.2% of subscription costs)
- 2006: $15 MM vs. $532 MM (2.8% of subscription costs)
- 2007: $21 MM vs. $664 MM (3.1% of subscription costs)
- 2008: $49 MM vs. $761 MM (6.4% of subscription costs)
- 2009: $91 MM vs. $909 MM (10% of subscription costs)
- 2010: $235 MM vs. $1,150 MM (20.5% of subscription costs)
- 2011: $531 MM vs. ???
As I said above, the 1st number is an estimate for the upcoming year, whereas the second is the “cost of sales” for that year. So, with more than a double from 2010 in estimated content costs, I’m expecting this to start taking a serious toll on margins. From what I’ve read, it seems Netflix signed the original contracts back when the content providers didn’t really understand the value of what they were giving up. They maybe figured Netflix wouldn’t end up with 20+ million subscribers, or that cable TV & DVD sales would get hit really hard by them. Either way, the content providers have all the power here and are looking to make up for large amounts of lost revenue.
So, with no end in sight to these increasing costs, there are some ridiculous prices they’re paying up for. One is the content on Mad Men at nearly $1 MM/episode. Next is the $100 MM or more that Netflix is paying on the Kevin Spacey series called House of Cards. Both of those announced after these results in the 10-k, and we should expect even higher than $531 MM on next year’s ann’l report. I do believe this will dominate the expenses on the income statement the next year or two at least.
So, the growth in revenues is decelerating, while the growth of costs is accelerating at a massive pace.. surely this is a good short if the stock is at a reasonable valuation even, so what are the current valuation metrics?
Op. Cash flows vs. Operating Earnings:
- 2006: $248 MM vs. $65 MM
- 2007: $277 MM vs. $91 MM
- 2008: $284 MM vs. $122 MM
- 2009: $325 MM vs. $192 MM
- 2010: $276 MM vs. $283 MM
The major differences between the two here are about $100-150 MM/year in additions to content library costs. Its all offset in the cash flow statement for what was incurred vs. what was paid in cash already. It seems 2010 was a year they paid back a lot of the cash to the content owners if you look closely at the cash flow statement. From a valuation standpoint, it’s much easier to do shorthand with the op. earnings than op. cash flows minus the content library costs, so just focus on op. earnings. They are at $283 MM in 2010, likely headed lower in future, and at $12.4 B, it’s trading at 2.3% yield to earnings. Sadly enough, shareholders won’t even get 2.3% moving forward- a large chunk of those earnings are going to end up going back to the content providers. I’m expecting a major sell-off for Netflix once Wall Street understands this… quite interesting.
So, with options prices too high to buy a put, I decided to do my first naked short. I made it a small position, but still made it large enough that I’d make a little once the stock collapses. In my mind, it’s not a question of “if” but “when” the music stops. I’m okay with waiting- I think Wall Street will catch on quickly once costs head higher & Reed Hastings sells even more of his stake.