Priced for Decadence

On March 11, 2009, we issued a call for value that was roundly derided at the time (see our letter and the comments it received here). The rest is market history. As those who sold at the bottom sheepishly return to the market, quick to rationalize their homecoming with the thinnest of facts, the market now looks vulnerable. As Sir John Templeton used to say: Buy at the point of maximum pessimism. The corollary is to sell at times of comfort when the market "feels OK" and prices have already priced in the warm, fuzzy consensus.

Certain stocks are no longer discounting just the future, but the hereafter. Netflix (NFLX), for example (selling at a 72 P/E ratio, 39 times book and a 2% cash flow yield) is priced at such levels of decadence, it would make Charlie Sheen blush. Let's get this disclosure out of the way: I'm short NFLX in a partnership I manage. Now you'll see why.

NFLX is an interesting story: it appears -- at first, myopic glance -- to be fomenting a revolution on a scale that only Colonel Gaddafi could ignore. Unlimited streaming is here to stay, and it's an obvious improvement to the fossilized business models it has blithely crushed: Blockbuster, on-demand, one-off rentals, you name it. The trouble is that NFLX is not only reinventing a market but also itself. It still has one foot in the buggy whip factory of physical discs, while it rushes to implant itself directly onto every coffee table. In a case study of eating its own young, NFLX cannibalizes its old DVD mailer model with its streaming, lowering average monthly revenue per user (ARPU) along the way. What NFLX will save on stamps it will burn on content acquisition costs, now that studios and distributors will demand grossly higher fees.

The trouble is that NFLX trades as though it's the new kid on the block, unburdened by primitive legacy accounts and invulnerable to a relentless race to the bottom in ARPU. It also holds the lofty price premium of the monopolist: a cash flow yield, for example, that implies little competition for the next five years. Unfortunately, for NFLX and its shareholders, competition is festering everywhere. The obvious transition to streaming is attracting the strong and the well-financed: the likes of Apple, Hulu, Redbox and Google. Amazon has launched the first true blitz, offering unlimited streaming through Amazon Prime (10 million subscribers and growing) for the annual price of $79. This $6.58 monthly fee undercuts NFLX by nearly $1.50 and offers the already popular unlimited free shipping as icing on the cake. Amazon has only 5,000 movies to NFLX's 20,000, but Jeff Bezos is not known for thinking small. The real problem for NFLX will be deep-pocketed buyers bidding against it for movies, in at-best Pyrrhic victories. Amazon's nearly $9 billion in cash and short-term securities can go flick-for-flick with NFLX and then some. With only $350 million in its own wallet, NFLX -- on a third world budget -- is entering an arms race with a superpower.

By discounting future expected cash flows, and giving NFLX the benefit of all human doubt, we can see the real problem. Even if we assume that NFLX is a "*#*#&@*% rock star from Mars" -- that it does conquer the world, vanquishes Amazon, makes an end-run around Apple, and routs Redbox, the stock price is still too high.

Take a look at a DCF analysis on Trefis and you'll see it in Technicolor:

The analysts at Trefis think NFLX is worth $119 per share, well below the market price of $206 -- and that's assuming a doubling to 50 million subscribers by 2017.

If you drag the trendline on the Trefis widget up to 80 million subscribers (try it -- it's fun!), you still get an intrinsic value of only $185 per share.

To get to 80 million households by 2017, NFLX would have to retain a monopolistic market share in streaming -- and to do that, they'd have to be on a drug more potent than the "Charlie Sheen."

NFLX is a well-run company with a terrific brand. It also has the first-mover advantage and a high growth rate. But it looks to be in the manic phase and vulnerable to a bipolar outcome, which on Main Street or Wall Street is called a crash.