Netflix is Still Way Overvalued

Nauman is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Netflix (NASDAQ: NFLX) currently trades at a whopping 613.50 times trailing earnings. Analyst expectations are for $1.31 in EPS for the current fiscal year, and the current stock price is still 145 times that figure. Netflix has a negative free cash flow margin, and when I look at the enterprise value implied by the current stock price it is 108 times trailing EBITDA, much higher than the rest of the industry.

Analysts expect revenue growth of 18%-20% this year, and if the company can still somehow manage to grow its free cash flow at a steep 25% rate for the long term.  Discounting that back, fair value on Netflix still comes out around $85 - making it one of, if not the, most expensive large cap companies today. I believe Netflix is simply not growing fast enough to justify its lofty valuation.

Quarter recap:

Netflix reported $945 million in revenue for the fourth-quarter of 2012, beating analyst expectations by about $10 million. The company produced a $0.13 profit, compared to an expected loss of $0.13. This has lead to a short-term rally in the stock. Netflix added more than 2 million domestic streaming subscribers, and I believe this was because of a colder winter -- apparently people decided to stay home and watch a movie rather than go out. Netflix also targeted former customers by offering free trials.

I think the real reason behind the domestic subscriber growth was just seasonality -- the fourth-quarter usually sees a higher number of new subscribers. Moreover, international revenue increased significantly in 2012 as compared to 2011, and was primarily due to the 260% growth in the international number of unique paying subscribers driven by a full year of service offering in Latin America, as well as by the expansion in the U.K., Ireland, and Nordic regions. International streaming subscriptions accounted for 18% of total streaming subscriptions at the end of 2012.

Threats and weaknesses

In DVDs, Netflix competes with Coinstar's (NASDAQ: OUTR) Redbox, which allows customers to rent DVDs at a kiosk. Recently Coinstar partnered with Verizon (NYSE: VZ) on a new service called Redbox Instant. This is a combo service that will allow customers to stream content online, as well as grant four one-night credits for DVDs from a physical kiosk. The two companies will be battling it out with dominant video streamer Netflix.

It’ll be interesting to watch how Coinstar and Verizon try to set their service apart from Neflix's red hue, which is closely associated with Netflix in the streaming market. I believe Redbox Instant's success could have a real impact in the DVD segment. Given that the DVD segment is a more profitable segment, the loss of subscribers there would have a lot more impact than Netflix's streaming losses.

Netflix's intention to focus more on streaming going forward will further shrink its margins in the future. I expect that going forward, Netflix's streaming margins of 20% will further cannibalize DVD margins, which currently stand at a much higher 50%.

Netflix's share count is also rising, which will put further pressure on net income per share in the future. In fact, Netflix's low cash flow margin won't allow the company to do a share buyback in the future either. As long as net income and cash flow levels remain stagnant, the share count will go up. If Netflix's 2012 share count was applied to 2011 net income, earnings per share would have been almost 10% lower--that's quite a difference.

Foolish bottom-line

Even after reporting more than 90% fall in earnings in 2012, Netflix's shares are still up more than 50% since the earnings report, whereas Apple on the other hand reported an excellent quarter, and is down more than 10%. Does it make sense? Apple's shares currently trade at 10 times trailing earnings and 6.8 times trailing EBITDA --  the lowest since the financial crisis of 2008 -- whereas Netflix trades at 613.50 times trailing twelve month earnings and 145 times this year's expected earnings.  Are there ample reasons to justify this lofty valuation? So far, the answer seems to be no.

Consequently, it is my view that the risk to Netflix's fundamentals are overwhelmingly skewed to the downside, which presents an intriguing trading opportunity on the short side. In short, Netflix is overvalued by many metrics, and after the premium provided by the most recent post-earnings-report rally, shares are certainly approaching the optimal risk/reward zone. I would wait for the shares to rise above the $200 level, as the shares present an attractive risk/reward there. Over-$200 is where I will start a short position.

MaaniValueGuru has no position in any stocks mentioned. The Motley Fool recommends Netflix. The Motley Fool owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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