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Netflix is flying too high

The online streaming giant is vastly overpriced and its growth is slowing, says Matthew Partridge.

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Will Netflix lose its crown?

The online streaming giant is vastly overpriced and its growth is slowing.

For the past few years the US stockmarket has been dominated by the fast-growing technology giants known as the FAANGs (Facebook, Apple, Amazon, Netflix and Google). And while we've been sceptical about Facebook in the past, no company underscores both the promise and the pitfalls of tech stocks more than Netflix, which was founded in 1997 as a DVD rental service.

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The big breakthrough came when it realised a decade ago that physical discs would eventually become redundant as faster internet speeds allowed people to watch films online. So the firm decided to reinvent itself as an online streaming service.

At first, Netflix just streamed existing films and TV shows. However, in the past few years it has invested large sums of money in creating its own content. This has proved to be extremely successful, enabling it to accumulate 130 million subscribers in 190 countries a threefold increase in five years. The stock has risen even faster, going from $85 in the summer of 2015 to a peak of $423 a few weeks ago.

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However, after some disappointing news a few weeks ago, the price has fallen back to $345. So, is this a temporary blip or the beginning of a steeper fall?

Running into trouble

We suspect the latter. The big problem is that Netflix is very aggressively priced, trading at 110 times this year's earnings and 69 times next year's. Even if analysts are right about its future earnings trajectory, it will still be 2022 before the stock is trading at a semi-reasonable 25 times expected earnings.

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This analysis is based on the assumption that Netflix will be able to triple revenues from 2017's $11bn in the same period. The idea is that this growth will allow it to spread production and other costs over a large user base, boosting profitability.

The problem is that Netflix is already seeing its subscriber growth starting to level off. In the US, the number of subscribers has risen by just 10% year-on-year. Globally, subscriptions are growing at an annualised rate of only 15%. The net number of new subscribers each quarter is starting to decline. This is partly due to mounting competition. Netflix's biggest rival is Amazon, which is pouring money into its own streaming service. Amazon's brand name and existing customer base make it a formidable foe, and it has deep pockets that could enable it to outbid Netflix when it comes to offering other content providers' shows.

Meanwhile, traditional media companies such as Sky are launching their own on-demand services. As well as stealing customers, they are bidding up the price of content. Netflix has had to cut its number of offerings and restrict some shows to its premium channels. We'd suggest that you short Netflix at $337.

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While IG Index allows you to short the company for as little as 1p per $0.01 (or £1 per $1), we'd be a tad more aggressive and go for £7.50 per $1. In this case we'd set the stop-loss on the short (so you'd automatically cover your position) at $437. This would limit your potential losses to £750.

Should you continue to short Tesla?

We suggested shorting Tesla in late April (issue 893). We felt that its price was too high given its failure to make money, production problems and growing competition from other car firms. Since then the price has been on a bit of a roller coaster, rising to a peak of $370, followed by a decline to $290.

However, the stock has surged in the past few days on the news that Saudi Arabia's sovereign-wealth fund had taken a stake in the company and a surprising tweet from CEO Elon Musk: he said he is working with a consortium of investors to take the firm private at $420 a share.

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Indeed, at one point last week Tesla was trading at $380, the highest level the electric-car company's stock has reached for nearly a year. While it has now fallen back to $355, this is still substantially above the $283 it was trading at when we first recommended the short.

Is it therefore time to close your position, or should you keep betting against the eccentric South African entrepreneur? Should you even go long in the hope that the deal will go ahead at a price that is nearly 20% higher than the current level?

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In our view, it makes sense to stick with the short position (though we wouldn't recommend that you increase it). This is because we doubt that the deal will actually go through.

Owing to Musk's recent erratic behaviour, the markets will be sceptical that he can find anyone to pay $420 a share, which would cost around $70bn. That would be a severe stretch even for the Saudis. However, if the deal collapses, then Musk could end up in legal hot water and this would trigger a massive backlash against the electric-car giant.

How my tips have fared

All but one of our long positions have performed badly in the past fortnight. IG Group has gone down to 870.5p (from 908p), Micron has declined to $51.34 ($53.04), Greene King is now at 482p (516p), Redrow costs 528p (532.5p), Wizz Air £33.84 (£34.26), Next £55.46 (£59.06), and Premier Oil 119p. The saving grace is Shire, which has risen to £44.32. None of these shares have collapsed, but the cumulative effect of these changes means that we've gone from a position where we were making £569.25 to being £156 in the red.

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However, while our long positions are looking a little worse for wear, our short positions have actually improved. As noted in the box at the bottom of this page, Tesla's price has surged thanks to rumours that CEO Elon Musk will take it private. This means we're now losing around £300 on our short on the electric-car company.

However, this is more than offset by the £1,297 in profits we are enjoying from Bitcoin's slump to $6,037. The upshot is that we're making a profit of £1,003 on our shorts, which produces a cumulative profit of £847 on all our open trades.

IG Group is making us a profit of £600 and is in the top 10% of the FTSE 350's best-performing stocks over the last six months. Still, we tipped it in May 2017, and changes to spread-betting rules since then will hamper growth. So I'm going to raise the stop-loss to 850p. This means that if the stock falls just a little further, we will automatically close our position and take our profits.

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