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Netflix: An Overvalued Long-Run Loser to Sell Now

Does Netflix still have room to fall? Let’s take a closer look and see if Netflix can regain its stride or if the company might be headed for more disappointment:

Netflix Inc. (NFLX) has been absolutely crushed in the last several months, falling over 65% since it made what is arguably some of the worst blunders in the history of modern corporate America when it decided to raise its subscription fees by up to 60% and tried to split its online streaming business from its DVD-by-mail business. Many Netflix subscribers were outraged and closed their accounts in protest.

In all, over 800,000 customers left Netflix in the third quarter. Management was very slow to react and attempt to ameliorate the situation. Since then analysts have revised earnings forecasts downward and its credit rating has been downgraded one notch by S&P to BB-. So the question remains, can Netflix repair the damage, get its mojo back and continue to dominate as it has in the past? Or is the company headed for more disappointment? This is not an easy question to answer. There are several factors that have to be looked at.

First, Netflix has no real moat except for maybe the economies of scale that it has with its DVD-by-mail model which many analysts believe will probably become obsolete at some point in the future. It now it has to deal with the U.S. Postal Service lengthening its delivery times due to severe financial pressures as discussed here.

In addition, the company now has a new competitor to deal with in its online streaming business as Amazon (AMZN) has now entered the space and will offer its service at a 17% discount to Netflix. There is even speculation that the movie studios that produce the films and TV shows that are the very product that Netflix sells might get into the game as well. Then there are the dozens of other Internet sites that offer streaming video on demand such as Hulu and Youtube which are currently the most widely used. And let’s not forget that about those red vending machines that we all see in the grocery stores that are owned and operated by Coinstar Inc. (CSTR), which recently announced a partnership with Verizon Communications, Inc. (VZ), to launch its own online TV and movie subscription service as mentioned in this Reuters article.

The bottom line here is that there are really no barriers to entry in this space. There is almost nothing stopping just about any company from entering it. The only thing that Netflix really had going for it was brand recognition, its reputation and momentum. Yhose can be very fleeting in the technological age that we are living in. Not that long ago Research In Motion (RIMM) seemed almost unstoppable, and now look at what has happened to them since Apple Inc. (AAPL) has entered that arena.

Shares of Netflix had a nice move to the upside during the last week along with the market as a whole, but it also received some good news from Washington D.C. as the U.S. House of Representatives passed a bill that will loosen restrictions imposed under an earlier law and will allow Netflix to share its video content through social networking sites such as Facebook as mentioned in this Associated Press article. The recent gains could also have been influenced by a presentation that CEO Reed Hastings gave on Tuesday that attempted to assuage investor fears that the company has lost its way and won’t continue on the same growth trajectory. Hastings also tried to dispel some of the fear about the prospect of competing with Amazon and Verizon.

Netflix had been growing its earnings very rapidly. Its trailing twelve month year-over-year quarterly earnings growth rate was an impressive 64.5%, which led to the almost meteoric rise of its stock price until its shares came under pressure and sold off sharply in the last few months. With the reduction of its customer base, the increasing costs associated with its streaming business model, and other competitive pressures, analysts are projecting that earnings per share will be much lower in 2012. In fact Netflix has a forward price to earnings ratio of a whopping 202 which means that if next year's earnings meet analysts' expectations, the shares look overpriced and are most likely due for another comeuppance.

With part of its business model headed for likely obsolescence and a plethora of new competitors entering its online streaming business, Netflix will most likely not be able to deliver the earnings growth that it has achieved in the past. At current levels Netflix shares are much more reasonably valued than they were a few months ago. With a trailing P/E ratio now at about 16, some analysts might argue that Netflix is probably even a little undervalued at these levels. I wouldn’t be surprised at all if Netflix shares got a dead cat bounce and rallied in the near term. However, in the long run Netflix will surely face many headwinds and the stock price will most likely underperform. Even though the shares of Netflix are well off their highs, I would recommend selling the stock until the long-term business fundamentals begin to look much better.

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