Why Netflix Could Keep Plunging

There is one huge risk when it comes to owning shares of high-growth companies. No one really knows how far or how close the company is to market saturation, so investors (and Wall Street analysts) are left to trust the company as it keeps issuing bullish guidance. When the era of strong growth finally comes to an end, few will have seen it coming.
 
That's the challenge that investors face with Netflix (Nasdaq: NFLX), a former highflier that may soon possess a fairly mature business model.
 
I laid out the looming challenges for Netflix roughly two months ago, and suggested either taking profits or shorting the stock outright. This week's plunge does not imply that the selling is done, and I still see this stock moving below $70 -- or possibly even lower in coming quarters.

Taking it on faith
In his review of first-quarter results, Netflix's CEO Reed Hastings noted that the company's growth in the current quarter will slow to a crawl, as rising numbers of streaming customers will be mostly offset by a commensurate dip in DVD-by-mail customers. The company is now pulling out all the stops to make this a streaming-focused business, taking a huge risk as the streaming business margins (roughly 15%) are a fraction of the DVD-by-mail business (40%-plus). The growth in the lower-margin business means that blended gross margins, which had been 29% in December 2011, fell more than 300 basis points sequentially. That's a huge red flag.
 
Hastings is asking investors to trust him that the shift to streaming will be a home-run and a magnet for new customers. But his guidance is a bit perplexing. The company added 1.7 million streaming customers in the first quarter and expects to add roughly 500,000 in the second quarter (using the midpoint of guidance). Yet for the full-year, the company pegs that figure at 7 million, implying that the second half of the year will deliver 69% of the full-year growth. This kind of back-end loaded guidance should always give you pause.
 
Meanwhile, I can tell you from first-hand experience that the DVD-by-mail business is slowly being starved. Almost all of the 20 titles sitting in my queue of DVDs that have been recently released are flagged with a "Very Long Wait" distinction. This tells me the company is ordering far fewer discs and is tacitly trying to nudge customers like me over to the streaming service. But here's the rub: I tried the streaming service last fall and found the selection of available titles severely lacking, effectively forcing me to tack back to the DVD-by-mail offering.
 
Hastings has made no secret of the fact that in an increasingly costly environment for content rights, Netflix will need to start offering more proprietary content and less licensed content. To be sure, it's not clear the company really has a choice, as movie studios and others are gearing up for their own Netflix-like services  and have little interest in aiding a key rival. (Please take a fresh look at my previous article for a fuller discussion of rising competition.)
 
Another key point that I've seen raised: The DVD-by-mail business has huge barriers to entry. The streaming business does not. Taken to a further level, Netflix may actually be at a disadvantage. For example, DirecTV (NYSE: DTV) is aiming for a major software upgrade this summer that will facilitate simple streaming on a wide range of devices. And the firm has the industry relationships to either hammer Netflix on cost or beat the company on timely content rights.
 
Slowing growth
Taken together, the streaming and DVD-by-mail business appear poised to modestly grow in the next few years as the market gets closer to saturation and rising competition erodes market share. That's why Netflix is vigorously pursuing an international expansion. The company is off to an impressive start, with 3.1 million subscribers, but it appears as if the company's marketing expenses are coming in much higher than forecast (leading to a $100 million quarterly loss in international operations). This helps explain why Netflix is expected to lose around $0.25 a share this year. Net/net, the company is emphasizing a pair of low-profit segments (streaming and international) and de-emphasizing the most profitable (DVD-by-mail), which just seems unwise.
 
No doubt, the international expansion -- if it pays off -- is to be applauded. A sacrifice in near-term earnings strength should be welcomed by investors, and indeed, Netflix looks to boost earnings north of $2 per share in 2013 and perhaps close to $4.50 per share in 2014 as the international drag diminishes and then becomes profitable.
 
Yet it's getting harder and harder to see how this company will find paths to growth beyond 2014. The U.S. market will likely peak by then and the international opportunities will have been more fully exploited. So do you really want to pay up for a stock that trades at roughly 40 times projected 2013 profits and 20 times projected 2014 profits?
 
There's a reason why cable companies such as Comcast (Nasdaq: CMCSA) trade for roughly 13 times projected 2013 profits and AMC Networks (Nasdaq: AMCX) trades for around 16 times projected 2013 profits. These companies produce solid cash flow, but are quite mature. It's only matter of time before investors realize that Netflix is much closer to being a mature business model than an industry upstart.
 
Risks to Consider: Netflix may eventually be the subject of merger and acquisition (M&A) chatter, but it's hard to see how a major entertainment company could justify such a purchase. Still, M&A buzz may create a short-term challenge for those wishing to short this stock.
 
Although it's hard to peg an appropriate valuation for this stock, it would be foolish to pay more than 15 times projected 2014 profits. This implies a target price somewhere in the high $60s (the stock is currently around $87). Netflix isn't likely to trade in such a precise fashion, so instead it will likely be the slow exodus of current investors who start to grasp the slowing nature of this business model that will force shares down. You should resist the urge to load up on this stock in the face of its current weakness and instead think about initiating (or maintaining) a short position.

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by David Sterman