Sizemore on Netflix: “Great Company, Bad Stock”

Can’t view the embedded player? See “Netflix: Good Company, Bad Stock

I chatted with CNBC’s Bernie Lo about Netflix’s (NFLX) 4th quarter earnings.  Netflix beat expectations in every way a company can beat expectations, increasing its customer base, revenues, earnings per share and even its gross margins more than the consensus Wall Street estimates.  Shares shot up nearly 15% on Thursday on the results.

The two biggest concerns for analysts have been rising content costs and the loss of “net neutrality,” which potentially allows internet service providers to extort higher fees from Netflix in order to give its streaming service continued access to premium bandwidth.

With Netflix competing for content with Hulu, Amazon (AMZN), Apple (AAPL), and Wal-Mart’s (WMT) Vudu services–and with the content creators aware of Netflix’s subscriber growth–it only stands to reason that content costs should rise, which–all else equal–should erode Netflix’s margins.  Thus far, it hasn’t been reflected in Netflix’s results; top-line revenues have grown at a faster pace than content costs, and Netflix’s gross margins actually improved last quarter.  But when subscriber growth starts to level off–which will probably happen sooner rather than later, as over half of all American households with high-speed internet access already subscribe to Netflix–margins will inevitably suffer.

As for the loss of net neutrality, Netflix CEO Reed Hastings is unconcerned, commenting that no internet service provider would welcome the negative publicity that would come with aggressively targeting Netflix.  I actually agree with Hastings here and would add that reality is far less important than perception.  Truth be told, Netflix “should” pay more for the disproportionate amount of bandwidth it uses.  But viewers upset that their favorite Netflix programs are buffering due to reduced bandwidth are far more likely to take out their frustrations on their internet providers.  In the war of public opinion, Netflix would have the advantage.

Netflix is a great company.  I would go so far as to call it a revolutionary company, in fact.  Largely because of Netflix, TV viewers now expect on-demand programming available on any device at any location at any time.  Traditional media distribution channels—such as cable TV companies—are scrambling to adapt their offerings to match the format of Netflix.

But even great companies can be lousy stocks if they are priced too expensively.  Netflix currently trades for 325 times trailing earnings and 55 times expected 2014 earnings.

Now, to be fair, Netflix should trade at a premium to the broader market.  It’s a fast-growing company and it deserves a high multiple.  But 55 times expected earnings?  That assumes that the high growth of recent years will continue indefinitely, which is a very dangerous assumption to make.

I also don’t like the persistent insider selling by company management.    As I noted in the interview, it is not uncommon to see insider selling in relatively young start-up companies.  Yet in Netflix’s case, the insider selling is heavy and persistent enough to get my attention.

Final analysis?  Netflix is on a roll, and it might be a fine short-term momentum trade.  If you are willing to watch the trade carefully and use stop losses or other risk management tools, then I would say buy it with your speculative “play money.”  But at current prices, Netflix is a terrible investment, and I wouldn’t recommend putting a dime of your retirement nest egg in its stock.

Charles Lewis Sizemore, CFA, is the editor of Macro Trend Investor and chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering market insights, global trends, and the best stocks and ETFs to profit from today’s exciting megatrends.