Stock of the Day - January 31, 2009 - NFLX

Netflix (NFLX)

Netflix (NFLX) has revolutionized the way that people watch and rent movies, and the online movie rental provider has been gaining popularity every single year since its inception in 1999. CEO Reed Hastings has been lauded for creating and running a company that provides an innovative service with a successful business model. Netflix is interesting because, while the company is doing everything right, it should only be judged by the way that Wall Street is currently treating its stock price. Follow me through my analysis of the company and my consequent reasoning for not labeling it a buy.

Netflix’s business process is actually pretty simple: Go online, create a queue of movies that you want to watch, they mail you the movies, and when you’re done viewing your movies, you mail them back with prepaid postage. The biggest difference between Netflix and competitors like Blockbuster (BBI) is the fixed rate of rent. Netflix charges a fixed monthly rate that stays the same regardless of how many movies you choose to see per month, and this translates into no late fees. Blockbuster, on the other hand, charges variably with each movie that you rent (with late fees).

It turns out that Netflix’s process has become the ideal form of affordable entertainment. The average user picks the  $17/month package that gives them 3 DVD’s at a time. This means that for $17 dollars, a Netflix customer can watch anywhere from 3 to about 20 movies a month when you consider the time it takes for mailing. By watching only the minimum number of movies per month (3), Netflix member end up paying a little more than $5 a movie, but with more movies, members could watch at a rate of $1 a movie. It is clear that Netflix provides an affordable service when you compare it to its biggest competitor, as Blockbuster charges about $7 for an in-store movie rental. To cap it off, Netflix has recently added 12,000 streaming movies online that can be watched at any time on its website, advertisement free. This service comes free with any regular subscription to Netflix. The cheap entertainment has been a recipe for success in these recessionary times, and people are subscribing to Netflix instead of going to movie theaters and theme parks.

Based on the merits of the company alone, Netflix seems like the perfect company to buy. But, it would be foolish not to analyze how Wall Street has been treating the company. Netflix last traded at $36.15, and the stock has a 52-week range of  $17.90 – $40.90. Incredibly, the stock was selling at its low of about $18 less than four months ago. Since then, the stock has doubled in price! Everyone is hopping on the Netflix bandwagon and, although it pains me to say it, if you haven’t bought it by now, it’s too late. The company has a PEG (5 yr expected) of 1.61, a statistic that tells me that the company is currently overvalued (Check out the Trillionaire Term of the Day on PEG Ratios - 1/30/09).

Now here’s the part where Netflix’s stock gets even more interesting. 27.9% of available Netflix shares are being shorted right now! The absolutely gigantic number of shares being sold short means that there is another bandwagon of people that believe too many people have jumped on the original bandwagon! If I haven’t completely confused you yet, these short sellers believe that investors overbought the stock and are betting that the price will fall very soon. To add to the complication, the large amount of short sellers may cause what is known as a “short squeeze.” This phenomenon can cause stock prices to skyrocket, because if people short selling the stock choose to bail out, they will be forced to buy the stock back in large numbers.

So, there are two possibilities for Netflix right now. A: the stock drops dramatically in price and the short sellers are correct in believing that the stock is overvalued. Or B: the stock continues to rise and we witness a short squeeze that drives the stock dramatically upward. I think that it is too much of a risk to bet on either one of these options, so I would not recommend buying the stock right now. The company has very solid fundamentals and provides a great service, so if it ever drops into the low-to-mid twenties, I would recommend a buy.  For current owners of Netflix, I believe that selling the stock and taking a gain would be your best option. Regardless, Netflix provides a perfect example of the unlimited possibilities and options that the stock market can create.

 

-Matt Schwartz

College Trillionaire