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
.
[block:block=16]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.
Action to Take -->
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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-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.