Valuation analysis for Netflix, Inc. (NASDAQ:NFLX)

Would you invest in a company that needed to acquire debt to gain customers and that also needed to acquire debt to retain customers?  The answer that question really boils down to earnings, because if the company can satisfy its debt requirements adding debt might not really matter, but if there is ever a hiccup and the company loses subscribers the massive debt load could become a serious burden.  I think that is the risks that investors in Netflix, Inc. (NASDAQ:NFLX) are facing.

The stock moves fast, that makes it something that's fun to trade, but as a long-term investment Netflix faces serious challenges.  Simply because individual investors like to hear it, I'm going to talk about things that I consider irrelevant to the fundamentals, and then I'll get to the meat of the matter.

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First of all, addressing those points that might make for interesting conversation, Netflix appears to have solid prospects internationally and that is likely to help the company gains subscribers at a more rapid rate overall, because domestic subscriber growth in the United States has recently been tapering off and that has been a concern.  On that note, the attrition of that domestic subscriber base is also likely to abate in my opinion, at least in the near term, with the addition of "Friends" to the Netflix streaming media portfolio.  This is a very popular television series and it will likely help Netflix retain subscribers that were on the edge.

However, that also brings to the forefront a very important relationship that must be observed.  As Netflix builds its subscriber base it is also assuming debt at a proportional rate, and that relationship is extremely risky for investors because it tells us that in order for Netflix to continue to grow it must continue to assume debt.

When we peel back the layers we can understand why.  Netflix must acquire streaming media rights and those are expensive, but more importantly subscribers can also become bored if the streaming media content does not grow, so not only must Netflix continue to acquire streaming media rights to build its subscriber base, but it must also do that to retain current subscribers.  As the company builds out internationally it faces those same challenges, and based on that I perceive there to be problems with the business model in general.

However, the meat comes from the raw numbers, and although revenue numbers improved recently, earnings growth is a major concern to me.  I will explain what I mean, but the Point I'm driving home is that in order for a company to look fundamentally solid it needs to bring earnings to the bottom line and until such time as it does that there are major concerns. 

My evaluation of earnings growth entails trailing 12 month data that is calculated on a quarterly basis and compared quarter by quarter and year over year to define both quarterly earnings growth and yearly earnings growth respectively.  The data I use excludes onetime events to focus on earnings from operations and below I have offered both the quarterly earnings growth chart and the yearly earnings growth chart for Netflix.

Netflix (NFLX) Earnings

Netflix (NFLX) EPS

The biggest take away from these observations suggests that quarterly earnings growth has begun to turn negative for the first time since the fourth quarter of 2012.  The yearly earnings growth is not yet negative, it still shows year over year earnings growth of 38% for Netflix, but I often find the quarterly earnings growth to be a precursor to what happens to the yearly earnings growth chart.

The impact this has on valuation is severe and the current peg ratio using that trailing 12 month observation is now 3.07 for Netflix.  Analysts are expecting nearly 80% earnings growth improvement in calendar 2015, so if that comes this raw data could look better, but the trajectory of earnings growth for Netflix does not currently suggest anything positive on a fundamental basis.  Analysts have also been wrong about their perceived earnings growth before and earnings expectations have changed over time, sometimes quite dramatically, so until such time as we see material improvements to earnings growth our fundamental observation is one of serious concern accordingly.

Technical take:

According to our real time trading report for Netflix (NFLX Report) the stock is rapidly approaching a longer-term level of resistance and if the stock tests that level we would recommend selling Netflix and also consider a short position in the stock.

Summary:

Although investors seemed giddy about Netflix right now, we consider the stock to be on shaky fundamental ground and rapidly approaching a level of technical resistance and therefore we would caution investors and suggest that anyone who has been considering taking profits do so when the stock tests resistance.  Resistance levels change over time given the slop of the longer term charts.

Disclaimer: Stock Traders Daily provides trading strategies, which by definition incorporate risk controls, and it has only engaged in buy and hold strategies twice since the turn of the century. The first was in October of 2002, and those buy and hold strategies lasted until 2006, and the second was in February of 2009, and those buy and hold strategies lasted until the end of 2010. Every point in between Stock Traders Daily has been providing risk controlled strategies, market based strategies, and strategies for approximately 3000 individual stocks, which are unbiased and which incorporate the notion that short term gains lead to long term success. There is a time and a place for buy and hold strategies and this is neither the time nor the place for that approach in our opinion. Risk controls are essential.

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