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“Short and Stupid”, or “God I’m Short!”

January 20, 2017

Yes, that could be a description of me, physically and mentally! (not really, I’m on the tall side, but for the sake of poetic license…)  I rarely ever take a short position. The only times I have, the outcome has more often than not been disappointing. In general, I think shorting is a loser’s game. To play it right you have to have a very different emotional mindset than the average long investor, and I really don’t think I have that mindset. But here goes anyway. I’ve shorted Netflix. I know. I know. Everyone will now think I’m either stupid or crazy, or both! Netflix is one of the biggest success story of the past decade both as a company and as a stock.

So why am I short? First let me say that my position is relatively small and I have set a limit on my potential losses. That said, I have a very simple thesis. Netflix earned $.15/share during the 4th quarter of 2016. It is trading at $140. That makes the annualized PE something like 230. What stock trades for a normalized PE of 230??? OK, so you think Netflix deserves that PE due to its blazing earnings growth? Not really. Check the figures, earnings are down over the past couple of years. They’re in subscriber acquisition mode. They’ve been reinvesting most of the incremental dollars from those incremental subscribers in what? marketing and programming! “Great!”, you say, “they are building a library that will increase their asset value”. You’re right, but the asset value is not growing as fast as they are burning cash. One of the problems is they are on a growth trajectory, driving subscriber growth by investing in original programming and marketing. It is unclear what will happen when they begin to reach subscriber saturation (acquisition costs increase for incremental subs) and they cut back on marketing. Will the subs stay? Will they stay if Netflix cuts back on new original programming? Will Netflix be able to bump up subscription costs enough to finance additional original programming AND incremental profits for owners? I do believe last year’s price increase saw some consumer resistance, and it really wasn’t that big an increase. Will new players come into the market (Amazon, Apple) and force Netflix to INCREASE their programming budget in the face of low, no or even diminishing subscriber growth? Will new technologies make Netflix’s streaming technology obsolete, just as Netflix is making linear cable program delivery obsolete? None of this is clear. However, it seems to me beyond common sense to pay 230x earnings (or even 50x earnings) for a company whose future is so uncertain. There you have it.

The sticky part of my thesis is that I could be 100% right and lose my shirt; its is not clear that the thousands of enthusiastic Netflix share owners will ever agree with me. They may be content to hold their shares when Netflix shares trade at 500x earnings i.e. at twice today’s stock price! There is no real catalyst to bring the share price down into the stratosphere, not to speak of to earth.

This is a calculated bet on my part. The market is priced relatively high right now. I think we could see a pullback sometime during the next year, and I think the Netflix share price will prove extremely vulnerable during any pullback. However, my strategy is full of giant holes. I’m ready to call it a day and eat my losses if Netflix shares continue their upward trajectory and hit $160/share. Yup, its like going to the casino floor and taking only $100 with you for ‘entertainment’. You leave your credit cards in the room and tell yourself that you won’t go back and get them. That’s why I’m writing this post… so I can’t ‘go back to my room and get my credit cards’. I’ll let you know how this works out…If I have mud on my face, so be it.

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7 Comments
  1. Parker Bohn permalink

    Hi, I’m a self-taught value investor and I’ve stumbled across your blog and I’ve been reading through some of your old posts this morning. Thanks for writing!

    It doesn’t fit my normal profile, but I went long NFLX in early 2015. I still hold about 1/3 of that position (as usual I’m conservative and sold too early, capturing ‘only’ a gain of about +60% on the 2/3 I sold).

    My main comment is that “the PE is really high” isn’t a good reason to short NFLX. If you’re valuing NFLX based on its current earnings, you’re doing it wrong. The current value of NFLX is based on its future earnings, which I think are quite substantial.

    I’m happy to discuss a couple ways I would think about the value of NFLX.

    Maybe this would have some value for you? After all, I don’t consider myself a hi-tech or growth investor. I don’t think “this time is different!” or “earnings don’t matter!”. I’m a value investor. I spend most of my time thinking about what could go wrong. I look at balance sheets and cash flow statements. I look for margin of safety.

    And I think that NFLX at the early 2015 price of 25-ish billion for the whole company was a demonstrably cheap price (despite the PE being, I don’t know, it wasn’t really a factor for me at the time). The current price of 60 billion may be fair. It may be expensive. It may even be cheap, it’s hard to tell! But I don’t think it’s super-expensive.

    Let me know if you want to discuss.
    And thanks for blogging,

    Parker

    • You’re right! P/E is not the end all and be all. You, and many others, continue to purchase Netflix based on the concept that their current investments will drive future earnings substantially higher. This may indeed happen. My point is that anticipated future cash flows are just that, anticipated; they are simply ‘projected’ based on what we believe might happen based on experience today. Projections can be deceiving! If you pay a lot for future cash flows you can be ‘surprised’ when they don’t materialize. Netflix, itself, introduced streaming as a ‘disruption’ technology and changed programming habits with their ‘binge-watching’ offerings. Who is to say that another technology might not disrupt theirs? or what if Amazon or Apple buys up NFL rights then funnel billions into their own original programming and offer it on a look-alike streaming service? What I’m saying is that investing in program delivery today looks to me more like investing in airlines than in Coke. What seems like a moat may not really turn out to be one.

  2. Nice Post!
    I also open value based short positions. Generally I don’t disagree with your reasoning. I would just like to add that I consider P/E as not suitable for finding overvaluation in such cases. Of course, profits matter but a big P/E alone does not say a lot.

    For a moment lets forget tech. If you have a company with $100M revenue and then a bad year and $100.000 profit…..it is a P/E of 1000. This is not overvaluation. Asking a P/E of 10 it just a capitalization of $1M. Is this a fair price? Maybe no, or yes, but P/E will not answer.

    I prefer to see P/Sales. Then I see growth and how much it will last. Then I assume a profit margin ..
    Even, if I don’t believe in strong profit and assume a break even condition, I calculate a p/sales of 0.5.

    I am not writing to disagree with Netflix short, but to say that P/E maybe is not the most suitable metric.

    • Absolutely right. I was using P/E as a kind of shorthand. If you look at the Netflix cash burn things begin to look even more precarious. Projections about Netflix are, to my mind, camped in air. The further out the future positive cash flows are the more they are susceptible to disruption by some unknown force and therefore the less certain they are (which we know means the discount rate to get them back to present value are higher). Technologies change, viewing habits change, economies change. I just meant for Netflix, the further out the projected cash flows ascribable to owners the more probable that they won’t happen.

  3. Parker Bohn permalink

    I think Netflix is still the “ramen noodles” of entertainment options. If ramen goes from $0.15 to $0.19 per package, people don’t say “that’s a 27% increase!”, they say “that’s a $0.04 increase”. It’s the same for Netflix.

    I can’t think of anyone I know who is willing to pay $10 a month for Netflix who would rather cancel than pay $12 (or for that matter $15). The average subscriber watches more than 1 hour of Netflix per day. Are they really going to bail because they’ll have to pay an extra $0.50 per week?

    I won’t get into trying to model future earnings, but I do think that Netflix has tremendous pricing power. I also think that, like Amazon, they are making a conscious decision to run at or around break-even in order to push growth as high as possible.

    Rather than looking at current earnings, I’d ask questions like:
    How many members will they have in 5 years (about 94 million members now and growing 20%+)?
    What kind of earnings can Netflix expect to get per member in 5 years?
    What is a reasonable PE to put on those earnings, and how does that discount back to the present?

    But I think like a long-term investor. Trading (including shorting) depends on near-term stock moves and is a very different game.

  4. work22 permalink

    Shorting growth stocks usually doesn’t work. The rewards are not significant enough to allocate capital. There are almost certainly better asset classes or ideas out there than shorting growth equity. If you are a hero in Netflix, you will make 30-50% on the trade. When will that be? 2 months? 3 years? You may take insane pain or be right quickly; but the time, research effort, and very importantly “mental capital” (ie, the psychological stamina) could probably be better allocated elsewhere. Into say, finding the next Netflix as a compounding long.
    There are of course bubble sectors like 3-D printing that made sense to short (i didn’t, but i would have done it soon frankly). You may be right on Netflix, i really don’t know– my point is that as a strategy for allocating capital, shorting growth equity superstars won’t serve you well over decades of trading/investing. Hope you don’t mind my two cents there. Good luck.

    On a lesser note, the bearishness and skepticism over Netflix reminds me of the same sentiments over Amazon in the early 2000’s, exemplified best by a neverending stream of Alan Abelson bearish articles in Barron’s. All wrong…

  5. Like your post — got me thinking. Good short in terms of issues u point out but they come out with new seasons next week/month which you drive/support the price. #2Cents

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