Is Reed Hastings The Modern Day Pied Piper?

Netflix Price Target $85.00

October 25, 2016 1:46 PM EDT

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(SI Newswire) According to thirteenth century German folklore, the Pied Piper of Hamelin was a character dressed in multicolored clothing hired by the townspeople to get rid of the rats that had besieged the town of Hamelin, Germany. Legend has it the Piper played his magical pipe luring the rats into the Weser River until all but one drowned. In the tragedy, when the citizens refuse to pay for his services, the Piper retaliates by using his pipe’s magical power to lure away all but three of the children from the town, never to be seen or heard from again. We wonder if Netflix’s (NASDAQ: NFLX) Chairman of the Board /Chief Executive Officer/President Mr. Reed Hastings is not the modern-day “Pied Piper” persuading his shareholders to look through rose colored glasses at Netflix’s prospects all the while leading unsuspecting investors to their doom.

To be sure, Netflix’s 3-in-1 boss is not looking through rose-colored glasses. Last Monday after the bell, the company released its third-quarter 2016 results, and Mr. Reed was must have been pleasantly surprised by the 20% gain in stock price on Tuesday and the additional gains over the subsequent days, so much so that he cashed out $9 million in stock options on Thursday, knowing full well the company was going to announce the sale of $800 million in junk bonds for his ever increasing cash burn machine a couple days later. According to Bloomberg, the company went even further and upped the amount to $1 billion when yield hungry investors showed strong demand for the product.

We are bearish on Netflix at the levels the stock has been trading within during the last few trading days. We believe once the market stops looking through Mr. Hasting’s rose-colored glasses, good old-fashioned fundamentals will become relevant and Netflix will have to deliver results just like other companies have to do. Our bearish thesis is formulated upon the following reasoning:

1. No big buyout in the works: Rumors have been swirling for years of a Netflix buyout, yet none has emerged. At one time or other, Microsoft (NASDAQ: MSFT) was supposed to be making a bid for Netflix, then it was Apple’s (NASDAQ: AAPL) turn, and most recently Disney (NYSE: DIS). Those wild rumors usually seem to gain momentum close to options expiration. Most observers don’t even believe the recently announced mega buyout of Time Warner (NYSE: TWX) by AT&T (NYSE: T) will come to fruition. Even if regulators okay the deal, AT&T shareholders seem likely to object. If a buyout were in the works for Netflix and with Mr. Hastings being the clever businessperson that he is, he would have waited for even further gains to exercise those 80,000 stock options. He very shrewdly exercised them after earnings but prior to the junk bond announcement. Bravo!

2. Netflix’s bonds rated junk: Netflix burns through cash like there’s no tomorrow. The company most recently announced an $800 million bond offering for content expansion, which Moody’s Investors Service promptly rated as junk (B1 or four steps into junk). Because of strong investor demand, the company tacked on another $200 million for good measure. We have a would-be comedian on staff here. Maybe we can get that staff person a $40 million contract with Netflix for a couple comedy shows. We’d even settle for half of that amount.

3. PE ratio severely out of whack: At what point does good old-fashioned fundamentals become relevant? At yesterday’s closing price, the company was trading at a trailing PE ratio of 335. At the end of October last year, the company was trading at a trailing PE of 278. At the end of October 2014, the PE was 100. This rate of increase implies a trailing PE of 500 by next October. When and where does the madness stop? This quarter, the company’s balance sheet showed a current ratio of 1.18. At the end of the third quarter of last year, the company had a more solid current ratio of 1.66. And even though the company had more profit this quarter than the third quarter of last year, it still didn’t surpass any of the four quarters of 2014. That’s right, all four quarters of 2014 showed more profit than any of the quarters so far this year.

4. Average revenue per subscriber underwhelming: The average revenue per subscriber came in at $26.40 for this most recent quarter. While this is an improvement over the amount for the same period last year of $25.17, it is still less than the $26.56 earned per customer for the third quarter of 2014. And while the average revenue per customer was better for the third quarter of 2014, the stock was trading back then at about half of its value today…in the $50s and $60s. Even though the number of subscribers surprised to the upside (based on lowered guidance earlier this year), the flatness of revenue per customer proves that sometimes more is just more.

5. Netflix commits fraud but urges others not to: According to Forbes, in March of this very year, “The poster child for net neutrality admitted to (secretly) throttling its own videos for AT&T and Verizon’s (NYSE: VZ) mobile customers, but not doing the same for videos watched by Sprint’s (NYSE: S) and T-Mobile’s customers. According to Netflix’s mea culpa, the company has been selectively throttling its videos on disfavored networks for over five years…Netflix never told its customers it was throttling the videos they paid to receive, which amounts to fraud.”

Netflix has committed a potentially illegal act on the competitive process, and by extension on wireless customers because its deceptive practice provides consumers who prefer high-quality mobile video an artificial reason to churn from AT&T or Verizon, which distorts the competitive process. All of this because Sprint and T-Mobile don’t oppose Netflix’s regulatory agenda, which involved reclassifying ISPs as common carriers so that payments for fees from edge providers such as Netflix to ISPs could be regulated out of existence.

Yesterday, Mr. Hastings was kind enough to give his consent to AT&T’s buyout of Time Warner so long as the resulting media and telecommunications giant offers equally speedy internet access to rival makers of TV shows and movies. According to Hastings, “If it’s open competition, we love that.” After throttling AT&T’s customers, we had to roll our collective eyes heavenward when we heard that particular bit of hypocricy. We won’t even elaborate on the double billing of customers in Australia and New Zealand last year in an “apparent billing error.”

Subscriber growth will slow as competition becomes more fierce in the space, especially from the likes of Amazon (NASDAQ: AMZN), revenue per subscriber will continue to underwhelmingly remain flat, and the company will continue to burn cash. Given all of this, we are assigning a price target of $85 to Netflix.

About us: Street Watchdog Research comprises a small group of investors, analysts, & short sellers based in Scottsdale, AZ. Our principals include Maxwell Athanis, Timothy Diggs, Cynthia Wayne, Angelene Dunlap, and Marissa Cabrera.

Disclosure: We are short NFLX. We do not have a financial relationship with the company.

Website: www.streetwatchdog.com

Email address: research@streetwatchdog.com



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