Walking through the halls of Netflix's (Nasdaq: NFLX) headquarters in Los Gatos, Calif., during the holidays must have been a gloomy affair.
Legions of employees that receive some of their compensation in company stock saw their holdings plunge in value as the video service company saw its shares fall below $70 by year end, just a fraction of levels seen earlier in 2011.
Well, Santa Claus finally showed up for these folks: Since this year began, shares have risen nearly 60%. That's a stunning two-month move.
This is a bad time to spoil the fun, but recent events have helped create a fresh set of troubles for Netflix.
The economics of Netflix's business model are weakening, competition is surging, and investors may soon start to focus on a 2013 price-to-earnings (P/E) ratio that has moved back up above 40. Add it up, and Netflix's next move may be back down, perhaps back toward the $70 mark or lower.
A window closes
You can understand why Netflix's shares soared ever higher until last summer. Even with the rising costs of physical distribution, postage fees and an expanding roster of content relationships, Netflix still managed to become extremely profitable. EBITDA margins rose from around 26% in 2007 through 2009, to around 38% in 2011.
Netflix became popular so quickly that movie studios and TV production houses were simply caught off guard. These content providers asked for too little from Netflix, assuming the company represented just one of many distribution channels.
Netflix's impressive profit gains changed the industry's thinking. Over the course of 2011, as a number of content relationships came up for renewal, Netflix was asked to pony up a lot more money. In some instances, the increases were so egregious that Netflix simply walked away. Cable channel Starz proposed replacing a $30 million annual content agreement with a purported $200-300 million deal. So the two companies have parted ways.
To its credit, Netflix has maintained that it would never sacrifice profit margins by overpaying for content. As CEO Reed Hastings noted in this December 2010 article: "Investors sometimes see the content cost threat as an issue around our margins. But we have no intention of overspending relative to our margin structure, and there is no specific content that we 'must have' at nearly any cost."
At the time he wrote that, Netflix was spending roughly $400 million per quarter to license content. That figure now approaches $700 million per quarter, according to analysis done by investment firm Needham & Co. Back in 2010, the firm figured Netflix could earn $42 a quarter in profit for each streaming customer, prior to other expenses. Nine months later, Netflix's rising content costs pushed that figure down to just $10.41.
You won't find those numbers on the income statement. Instead, it's the balance sheet that investors should be watching. Netflix's capitalized content costs rose 54% in the fourth quarter of 2011 compared with a year ago. That means content costs are growing faster than sales. Needham's analysts predict that, "unless Netflix brings the growth in content costs in line with the growth in streaming subscribers, our analysis indicates the company's domestic streaming business could soon become unprofitable."
Amazon, Google, Verizon, Comcast -- when will it stop?
Netflix's success has surely been noted by many other companies. From Internet access providers such as Verizon (NYSE: VZ) and Comcast (Nasdaq: CMCSA), to online powerhouses such as Amazon.com (Nasdaq: AMZN) and Google (Nasdaq: GOOG), Netflix-style video streaming services are expected to either launch or ramp up this year at a host of rivals.
And that's just the companies we know about. If Hulu.com gets acquired, then analysts think it will represent Netflix's stiffest competition.
Investors in Netflix have quickly realized that this business has few barriers to entry. At least the DVD-by-mail business was harder to replicate because Netflix had built a massive national network of DVD distribution facilities. Assuming these companies take the opportunity seriously, then it's impossible to see how Netflix can maintain its current market share.
Even before that competition really starts to bite, Netflix's U.S. customer base may be rapidly maturing. In the fourth quarter of 2010, the company added 3 million net new subscribers. Four quarters later, that figure slipped to 250,000. Only the 650,000 new international customers added in the quarter helped save the day and enabled Netflix to slightly exceed fourth-quarter forecasts.
Impressive as the international launch may look, management now concedes the international business is developing below internal plans, leading to a drain on profits in 2012 as international marketing costs move higher. Netflix is currently losing $14 a month per international customer when marketing expenses are included.
Even before the big Q4 international marketing push, margins were falling
Risks to Consider: Netflix is still heavily shorted, with 10.7 million shares held short as of the middle of February. Further gains in the broader stock market could lead to a short squeeze, pushing shares higher.
Action to Take --> As noted earlier, Netflix's rebound has pushed the stock back up above 40 times projected 2013's consensus earnings estimate of $2.60 a share. Yet analysts at Sterne Age think that target is still too high, anticipating $2 per share. That puts the 2013 multiple at an eye-popping 55.
In light of all of the looming headwinds, shares are once again set up for a large fall. Netflix remains an impressive company, but as it moves into maturity, shares are likely worth no more than 25 times projected 2013 profits. This implies a price target of $50 to $70, depending on how actual profits fare next year. Either way, the current $110 share price looks pretty rich. If you own this stock, you should consider getting out now. And if you're feeling aggressive, you might want to short the stock.
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