Is Netflix (NFLX) a house of cards? The stock has certainly seen dramatic swings, dropping from the $300 range in 2011 all the way to $50 or so before bouncing back to over $250 recently.
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There is no doubt that this company has made headlines in the relatively short period since its initial public offering in 2002. In barely a decade, it went from unknown to household favorite with its movies-on-demand streaming subscription service propelled in part by the parallel success of the iPad and Android devices and its service has become standard fare for consumers and commuters needing some distraction without having to go out to the cinema.
With a market capitalization of some $15 billion, it had made founder Reed Hastings a lot of money not to mention those fortunate enough to be long or short at the right time in its short history. Speaking of “short history,” it has also been a favorite of short sellers with just over 7 million of its 56 million shares outstanding sold short. Options traders love the stock as well, particularly option sellers who can coin juicy premiums if they can time their sales to avoid some of the many adverse swings that have left more than one trader in tears.
The company’s fundamentals tell part of the story. Sporting a price to earnings multiple of over 600 times and living in the rarefied atmosphere of high tech darlings, it is a stock not for the faint of heart regardless of their bull or bear leaning.
No one should be surprised that Netflix does not pay a dividend. With earnings per share of $0.41 in the past 12 months and a stock price of $265 per share, a dividend would look like a rounding error. Book value of about $15 a share provides not much in the way of tangible asset value to support the share price and, surprisingly for a stock where the market has been willing to pay an enormous premium for shares (making the cost of equity capital pretty low), the company has $700 million long-term debt sitting on just over $800 million book value of equity.
Does anyone smell an issue here?
It is plain and obvious that Netflix bulls are betting big time that the company will grow sales and profits quite dramatically for an extended period of time to grow into its valuation. Insiders, reluctant to wait I guess, have been sellers.
Netflix might be worth $265 a share if it had a quasi-monopoly on streaming video entertainment, but of course there are other players in this game – Amazon (AMZN), YouTube, and Hulu to pick three – and over time we can expect Apple (AAPL) to continue to expand its iTunes service to an offering as broad and deep as that of Netflix. On the other hand, Netflix seems to have been successful in attracting former Pay TV subscribers who have shifted to Netflix and cut the cord on Pay TV. This together with innovative and exclusive content such as “House of Cards” and the company’s heady growth make up the bull case and the risks to short sellers.
In my view, all of this adds up to a pretty good short, not without risk, and possibly a crowded trade. A better way to get short is probably to buy in the money puts to keep the premiums as low as possible and maybe a put spread. The benefit of the puts is the limited losses if it turns out the bulls are right and the freedom from any short squeeze should the stock have a rapid rise.
I don’t have a position in NFLX, but by the end of Monday’s trade, I will be exposed on the short side one way or another. I think the earnings release due out after the close Monday will be a catalyst for a sizeable move on the stock and my bet is that it will be down. The market has not been kind to companies that miss expectations. Google and Microsoftboth missed expectations, and in each case, their stock dropped sharply after their recent quarterly releases.
At over 600 times earnings and trading at over 100 times trailing twelve months EBITDA, Netlflix is expensive by any traditional measure. Netflix’s price to earnings growth multiple of 5.25 is at a nosebleed level when compared to 2.01 for the market at large (Source: First Call). Multiples at these levels imply extraordinary earnings growth expectations which certainly applies to Netflix, with First Call consensus expectations for $0.40 per share net income for the quarter versus $0.11 last year, or a 263% increase, and full year earnings of $1.40 versus $0.29 last year.
Extraordinary is possible but unlikely in my view. I will be on the short side of the stock for a trade on the earnings report by buying puts if I can buy them at a premium I can stand.