David Trainer: In November of last year, Netflix, Inc. (NASDAQ:NFLX) ~$355/share landed in the Danger Zone after rising 363% year-to-date on promising quarterly results and much media hype. The stock rose rapidly for a while after our pick but has come back down nearly 20% in the past month.
Early last month, Netflix filed their annual 10-K, allowing us to update our model with its most recent financial data. While 2013 was a positive year for Netflix in some respects, many of the concerns in my November article were confirmed. Margin compression, fierce competition and high content costs are all hindering the already unrealistic profit growth priced into Netflix’s stock. Our original sell/short thesis is proving true as more evidence mounts that the NFLX business model is fundamentally broken.
Underlying Fundamentals Are In Decline
After Netflix’s rocky 2012, it was easy for the company to improve its performance in 2013. Netflix grew after-tax profits (NOPAT) from $33 million to $148 million, and grew its NOPAT margins from 1% to just over 3%. In addition, Netflix’s return on invested capital (ROIC) rose from 2% to 7%.
In general, this would be excellent performance for most companies, but considering Netflix’s track record before 2012 and its current valuation, the company is underperforming. In 2009, Netflix earned a NOPAT of $119 million. That means over the past five years NFLX has grown NOPAT by just $29 million, or just 4% compounded annually. This slow profit growth is largely due to two factors: rising content costs and the decline of Netflix’s high-margin DVD rental service.
Business Model is Busted
Judging by Netflix’s 2013 annual report, it does not look like either of these trends will reverse in the future. Figure 1 shows how the total value of NFLX’s obligations for streaming content has surpassed its annual revenue.
Figure 1: Streaming Content Obligations Outpace Total Revenues
Netflix is seeing decreasing returns on capital as its costs rise. Since 2009, Netflix’s revenues have grown by 27% compounded annually while its costs of revenue have grown by 30% compounded annually.