The endgame for Netflix (Revised)
I subscribe to Netflix. It provides a great service (commercial-free movies) for just $9 a month. I am also selling naked call options on Netflix’s stock (NFLX), with a notional value equal to 5% of my portfolio.
I came across this idea while reading Katherine Burton’s Hedge Hunters. In Jim Chanos’s profile, the great investor explained his rationale for shorting NFLX, which went something like this:
The business of mailing DVDs is one day going to become obsolete. The owners of the entertainment content, one day, will figure out a way to provide their content to people without Netflix as the middleman. You would be crazy to pay 30x earnings for NFLX stock.
As usual Chanos’s timing was off, yet I think he’ll ultimately be right. There’s no doubt that Netflix has dominated the physical distribution of movies with its efficient by-mail model. However, the odds are high that streaming/downloading will become the de facto means of movie distribution over the next few years. This is a win-win proposition as content providers pass on their lower costs to consumers. For a prelude to the death of physical distribution of movies, we only need to see what has happened with sales of CDs and books when digital alternatives became popular.
I believe that Netflix will lose its current status as low-cost distributor to someone who can figure out the streaming business, where it has no competitive advantage other than having an installed base of users. Netflix’s streaming library is half-assed compared to what’s available via DVD by mail. Why? Netflix usually pays content providers a fixed fee for the right to stream movies to subscribers, who can watch as many programs as time permits. Content providers would never agree to receiving a fixed fee for content they deem popular–unless the fee was exorbitant. So far Netflix hasn’t figured out the ideal pricing arrangement.
How elastic is demand for Netflix’s services? I found it encouraging that this past fiscal quarter subscribers flocked to the cheapest monthly plan. This implies that any price increases from Netflix may be met with customer defections. Of course the intensity of this will be more severe when someone comes in to compete with Netflix.
I think that content providers are in the process of cutting Netflix out of the distribution channel. Hulu.com is making inroads as far as television programming is concerned, and it’s only a matter of time that the movie producers catch on. There’s also a high probability that Apple will do with movies what it did with music.
Whenever I short a stock I make sure that the accounting is aggressive–this is like a margin of safety in case the operations of the business do not deteriorate as expected. Netflix capitalizes its DVD acquisition costs over a useful life of three years instead of expensing them when incurred. This adds a degree of subjectivity to what the company is truly earning. It’s interesting that book value has been declining rather than increasing over the past few years.
Netflix borrowed a large amount of money to buy back shares in what seems to be an attempt to intimidate short sellers and increase earnings per share. At the same time, CEO Reed Hastings and other executives continue to exercise millions of dollars worth of stock options and sell in the open market. Netflix executives are getting on lifeboats while leaving shareholders on the Titanic, and they probably know it. Mr. Hastings, if you’re reading this, I challenge you not to sell any more stock.
As I see the competitive landscape evolving, shorting NFLX call options appears to offer attractive rewards given the risks.
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[...] also a fan of the investing blog Stableboy Selections, which did a post this summer about shorting Netflix. I thought he raised an interesting point about the way Netflix accounts for DVD acquisition [...]
Why not Gamestop? Isn’t the practice of driving to a store to buy a game on a plastic disc even more doomed than Netflix’s two business models?
I think Netflix’s end game will take time. We aren’t there yet with the capacity to stream at the bit rate to support 3D HD that will look good on your giant plasma. We’ll need physical media until that can be provided. 10 years maybe? I don’t know a lot about advances on the horizon in that area.
I’ve heard some discussions about shorting GME, but I haven’t gotten around to think about it deeply. The concept of driving to a video game store might not be so silly if, at some time in the future, games require huge amounts of storage space and streaming speeds do not improve remarkably. Actually if there’s any type of entertainment that might require high-capacity disk drives, it would be video games. I imagine that Playstation 4 will have 3D/HD capability (btw you might want to check out the official “trailer” for it on youtube), and that each game might require many times more capacity than today’s games. The death of physical media would be more likely to hurt distributors of entertainment that require less storage space.
Interested to know more about the Netflix trade. What strike and what month and curious to understand your thinking as to that selection (so how you arrived at the choice).
And good move on VPRT.
I suggest looking at Opentable. I’d be interested to hear your thoughts on how you might play it.
I wouldn’t short Opentable, but I might consider selling naked call options against it. The risk of a short squeeze can be reduced by doing so.
Would you be able to provide some additional insight into what strike and month you personally would write if you were going to write one on Opentable? It’s helpful to hear your thinking. Thanks in advance.
Why short calls vs. buying puts or just shorting stock? Given the potential for volatility in NFLX, it seems like you have capped your upside while allowing for potentially material downside. Interested in hearing your logic on that decision.
Assuming that you keep notional value the same size as a short position you’d have on otherwise, there is less risk in selling naked calls. If the stock moves up, you can easily net out the short call position and guarantee at worst a break-even result (assuming no overnight jump up). There’s probably an 80% chance of making money by next month’s expiration, but the probability is much lower for a straight short position. I might as well sell time value to speculators.