Tuesday, March 8, 2011

Why I am Short Netflix, Inc. (Nasdaq:NFLX)


Netflix, Inc. is a subscription based service, providing access to thousands of movies and television shows on demand to over 20 million subscribers. Recently, the most vocal short-seller, Whitney Tilson of T2 Partners closed his short position. I believe that Tilson was right in shorting Netflix, and when Tilson closed his short position, it actually sparked the recent peak for Netflix (as all major analysts and investors in NFLX were then buyers of the stock).

Why is NFLX so successful?

Netflix was first successful in filling the vacuum left by Blockbuster’s bankruptcy. Blockbuster’s bankruptcy fragmented the movie rental business, allowing another company to step in, and take further market share. While Netflix was the market disrupter that proved to be the catalyst for Blockbuster’s demise, it was also the temporary beneficiary of Blockbuster’s losses. Innovativeness allowed NFLX to move with consumer demands, especially when it moved to the streaming subscription service from its mail-order DVD rental service. I believe that both the market gains from Blockbuster’s bankruptcy and Netflix’s innovativeness will only be temporary gains for the company. Eventually content-owners will try to capture much of the supernormal returns (charging more for content, or in the form of competition, as the Warner Brothers/Facebook deal shows), and further third party competition (like Amazon and GoogleTV) will reduce earnings to more normal levels. Competition is only starting to heat up, and access to the lucrative European markets is already threatened by other early entrants, which could restrict profitability in the region.

Aggressive Valuations

Regardless of all my theses above, let’s consider what could happen if NFLX were to achieve 50% market share in the United States, based on current market conditions. Currently, there are 83.3m broadband subscriptions in the United States (Source: OECD, http://www.oecd.org/document/54/0,3343,en_2649_34225_38690102_1_1_1_1,00.html), with intentions to increase this to 100m households with broadband access by 2020. If we assume an aggressive 50% subscription rate, at the current $7.99/month subscription rate, we arrive at $4b in annual revenue. The historical expected gross margin rate appears to be around 35%, resulting in $1.4b in annual gross margins.

I have assumed that the OPEX run rate would have to stay at the current 25% rate, as Netflix would have to continue to be aggressive in its marketing of the service in the face of higher competition, as well as in continuously trying to be the first-entrant to new technologies. At 25%, OPEX is expected to be $1b/annually, which results in an annual net operating income of $400m.

If I apply P/E of 20 to the net operating income (I applied an aggressive P/E to match with the typical technology stock, as well as allow for errors in other assumptions), I arrive at a market capitalization of about $8.0b. The current market capitalization is over 20% higher than this aggressive figure! I realize that expansion internationally is possible, but this would not necessarily lead to $8 monthly subscription costs in other countries, and content costs would increase as foreign language films and institutions would need to be added to the company’s library.


Based on the above findings, and the recent parabolic move in Netflix (from $180 to $245 in about 15 trading days), I believe that short sellers can still be rewarded in shorting NFLX here, even after its move below $200 today.

I am currently short NFLX. These statements are for entertainment purposes only, and should not be construed as investment advice. Please contact your investment advisor before acting on any information.

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