Fantastic Read: Why We’re Short Netflix

Although not in the same league as David Einhorn, T2 Partners are reputed in their asset management and return generating skill. In this article, they lay out a case of why exactly they are short Netflix, and that too with a large position.

It’s an amazing read, not just for the financial analysis but also at various angles they looked at before they got convinced that they should short Netflix. (Netflix, by the way, appeared on the Forbes  where the CEO was the #1 Business Person of the year in 2010. This, in my opinion, is a great indicator for going short. Enron, anyone?)

The article:

The entire article is a must read. Some tidbits from the article:

Our favorite shorts generally involve some or all of the following characteristics: outright frauds (our very favorite), industries in decline or facing major headwinds, lousy or faddish business models, bad balance sheets, and incompetent, excessively promotional and/or crooked management.  In general, we prefer to short businesses with these traits, even when their stockstrade at seemingly low valuation multiples, rather than shorting the stocks of good businesses with strong managements, even at high valuations.  Sometimes, however, the valuations becomeso extreme that we will short the latter, but generally only when we believe there is a catalystthat will impact the company and cause the stock to fall. Netflix falls into this latter category.

…because we think the valuation is extreme and that the rapid shift of its customers to streaming content (vs. mailing DVDs to customers) isn’t the beginning of an exciting, highly-profitable new world for Netflix, but rather the beginning of the end of its incredible run.  In particular, we think margins will be severely compressed and growth will slow over the next year.

Netflix’s core business model is buying DVDs and then renting them to its customers, who pay a fixed monthly fee for unlimited rentals delivered by mail plus unlimited streaming. This is a good business for two reasons: 1) Netflix has a better business model and better management than its bricks-and-mortar competitors such as Blockbuster and Movie Gallery,both of which filed for bankruptcy this year (the former continues to operate as it tries torestructure, while the latter has been liquidated); and 2) Netflix only has to pay once for the DVDs it rents over and over again to its customers thanks to what’s called the First Sale -3-Doctrine, which allows anyone who buys a DVD to sell, exchange, rent, or lend it to others, without paying the content owner

Netflix’s core DVD-based business model is rapidly shrinking as customers shift rapidly tostreaming content. Netflix has moved quickly to adapt, making its streaming service availableover the internet to customers’ computers as well as through various devices like iPads and iPhones, Tivos, game consoles….

…, our answer is that we believe that the same two factors that made Netflix a good business under its original business model don’t apply under its streaming model.

…In short, Netflix is moving from a business in which it was competing against smaller, dying, heavily-indebted companies with inferior business models to some of the largest, most powerful,aggressive and deep-pocketed companies in the world, which have big competitive advantagesover Netflix.

Unlike renting DVDs, in which Netflix is protected by the First Sale Doctrin, the laws around streaming contentrequire that Netflix must have an agreement with the content owner to stream it.  This is very badnews for Netflix because content owners are generally very savvy and are seeking to carefully control their content to maximize revenues.

Another risk factor we see for Netflix is that the company is much closer to saturating its marketthan is commonly believed.  The bulls argue that the company’s 16.9 million customers representfewer than 15% of the 115 million households in the U.S., but the company’s churn data presentsa different picture. We have analyzed the last decade of Netflix’s quarterly statements, in which the company discloses customer additions and cancellations, and calculated that Netflix has had approximately 30 million customer cancellations.  In other words, the company has had to add approximately47 million customers – more than 40% of U.S. households – to be left with today’s 16.9 millioncustomers (and many of these will cancel in the future; the churn rate last quarter was 3.8%). If history is any guide (we think it is), Netflix will need to somehow find another 47 millionsubscribers for the company to double its current subscriber count (a common medium-termobjective in many analysts’ view). We don’t think that many potential additions exist.

We don’t think there are any easy answers for Netflix.  It is already having to pay much more for streaming content and may soon have to pay for bandwidth usage as well, which will result in both margin compression (Netflix’s margins are currently double Amazon’s) and also increased prices to its customers, which will slow growth.Under this scenario, Netflix will continue to be a profitable and growing company, but not nearlyprofitable and rapidly growing enough to justify today’s stock price, which is why we believe it will fall dramatically over the next year.

Amazing analysis. As usual, we would know if T2 partners were visionaries (the reason attributed if Netflix goes down) or dumbs (reason attributed to analysts who suggested/shorted Amazon) only in hindsight. Neverthless, great learning in terms of how you look at a business and value it.


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