NFLX Short Interest, Regulatory Intrigue & Income Opportunities

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Over the long arc of time, investors' reliable penchant for following the herd and ricocheting from greed to fear at precisely the wrong moments affords disciplined investors the opportunity to compound wealth at higher rates with far lower chances of permanent impairments. Short sellers have been ridden out on a rail. First, through the combination of free money and a speculative mania that, by many measures, eclipsed the dot.com bubble. Now, those same folks have come under regulatory attack post the short squeeze chaos around GameStop. Suddenly short interest data, short positions, and the number of shares sold short at various issuers have become an issue of public interest. As Barron’s explained, some short sellers allegedly engaged in the practice of publishing bearish research on a stock and then covering as their reports sent the stocks lower. KCR can see how that would draw the ire of both investors and regulators alike. What’s less clear to us is why the same behavior by prominent long-investors doesn’t stimulate the same upset and regulatory inquiries. Netflix Short Interest Troughs Post Recent Price Declines We are left to wonder if this lopsided regulatory push is merely amplifying already prominent behavioral errors. Inefficient markets combined with an ever-growing affinity for indexing have possibly, increased the human tendency to “anchor” on things that have no relationship with intrinsic value. The chart below shows the stock price and short interest in Netflix since 2011. On the one hand, with the stock price down -65% since the peak in October of 2021, a reduction in short interest is to be expected. On the other hand, … YOU ARE NOW READING BASIC MEMBER LEVEL CONTENT …. just because a mania darling was valued at $300bn at the peak does not mean that the company’s current $110 billion market cap makes it cheap. The chart below is the same as the chart above, with one difference that completely changes the story. https://kailashconcepts.com/wp-content/uploads/2021/11/icons8-vertical-line-50.pnghttps://kailashconcepts.com/wp-content/uploads/2021/11/icons8-lock-50.pngSubscribe now to unlock the full content 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YOU ARE NOW READING BASIC MEMBER LEVEL CONTENT …. just because a mania darling was valued at $300bn at the peak does not mean that the company’s current $110 billion market cap makes it cheap. The chart below is the same as the chart above, with one difference that completely changes the story. We switched out the “stock price” for how big Netflix’s market cap is compared to all other US large-cap stocks. Despite the -65% decline, Netflix is still larger than 93% of all other large-cap stocks. Market Cap of Netflix, Percentile of the Large Cap Index (LHS) vs Short Interest NFLX (RHS) So, the question for investors is: “Does the fundamental evidence support the idea that Netflix should be bigger than 93% of the largest companies in America?” The analyst community has seen the share price movement and, predictably, some are beginning to shift to a bullish stance. A recent article noted that after its -60% plunge, making Netflix the fourth worst performing stock in the Nasdaq 100, “analysts are increasingly…betting that Netflix Inc.’s move into advertising can help turn around the performance…” One could be forgiven for finding irony in the fact that Netflix, an early mover in ad-free TV on the internet, now has a bull-thesis predicated on becoming just old-fashioned TV on the internet. The whole escapade reminds us of this classic clip from the HBO hit series Silicon Valley. The profane snippet is a hilarious and healthy reminder of the importance of “ROI” once “bubble-economics” type thinking vanishes. We encourage our readers to watch the clip and then contemplate the question below: What is the difference between a creative film and TV studio, and a creative film and TV studio…. on the internet? KCR humbly suggests that there really is not much of a difference at all. Particularly if the business case rests on the same revenue model the once vaunted darling supposedly was putting an end to. The chart below shows what percent of US large caps Netflix is more expensive than based on free cash flow to enterprise value since 2002. You can see that back in early 2002, Netflix stock was only in the 6th percentile. So, before it began its glorious rise, Netflix was cheaper than 94% of US Large Caps! In those dark days, Netflix was a dreaded “value stock” and was dirt cheap. Today, the company is in the 82nd percentile even after the violent decline. So, post a -60% wipeout, Netflix is still more expensive than 82% of all US large-cap stocks. By this measure, the company is still very much a “growth” stock whose valuation depends largely on future successes. We are not here to say such successes are not imminent and possible, merely that they better materialize sooner than later. George Noble is fond of saying “price is not truth.” KCR agrees. Netflix strikes us as a classic case of a bull market darling that has fallen sharply yet is still very expensive. KCR is not in the forecasting business. Plenty of other ways for us to look foolish. We are in the empirically derived evidence-based probabilities business trying to identify undue pessimism and optimism. For long investors in Netflix, we wish you many a dead-cat bounce and excellent market timing. But we’ll stick to our knitting and continue to view investments as fractional shares in actual businesses. And on that front, Netflix looks grim. Tapping the stock into our proprietary single-stock dashboard reveals that Netflix ranks near the bottom of our model. The ranking tool scores the firm’s Balance Sheet and Earnings Quality as average. Yet the company’s terrible score on valuation across multiple factors is the principal reason our ranking tool dislikes the stock. Possibly of more interest is what our model cannot see. The exhibit below is from Netflix’s most recent 10-Q. Our model calculates FCF/EV based on what is on the balance sheet. Things that are not on the balance sheet are…not on the balance sheet. Netflix does a good job disclosing the company’s off-balance sheet liabilities and their reporting limitations. As you can see in the highlighted portions below, there are $15.6 billion in off-balance sheet obligations that our model cannot see. Look at our highlights at the bottom of the footnote. There is more debt. As the company explains, they “...do not include any estimated obligations for future titles beyond the minimum … unknown obligations are expected to be significant.” (Emphasis ours) So, to better comprehend Netflix’s valuation, we must take the on-balance sheet enterprise value of $110 billion and add on this new $15.6bn in off-balance sheet debt to end up with a company valued at $126 billion. And that excludes the “significant” other unknown obligations we highlighted at the very bottom of the footnote. According to Compustat, Netflix generated $160ml in FCF over the trailing four quarters. Incredibly, if we back out stock-based compensation, the firm actually burned cash. Ignoring the SBC issue, if we simply divide the “pro-forma” $160ml in FCF by the $126 billion enterprise value, the company has a 0.1% free cash flow yield. This is an expensive company with a lot of debt and insignificant cash flows valued like a high-flying growth stock. The news out of Hollywood, however, is not one of growth. Once flush with cash and cranking out content, the retrenchment has begun with layoffs everywhere.,, For stockholders this might be good as it will reduce costs and possibly improve cash flows. For cash flows to improve, however, investors have to believe that declining amounts of new content will not negatively impact subscribers and revenues. Let’s pretend that sharply reducing their content offering does not slow the company’s revenues. For Netflix to merely match the Russell 1000 Index average, they would need a 3.6% FCF/EV. That is tough news for those hoping to see Netflix generate actual cash flows to justify the current valuation. FCF would need to grow nearly 30x fold from $160ml to $4.5bn. ($4.5bn in FCF/ $126bn EV 3.6% and signified by the light blue dot below). For those wondering how likely that is, the past offers some insight. In the halcyon days (for streaming businesses) of the Covid outbreak, Netflix saw a double benefit. Subscriptions exploded as the world was suddenly home-bound and production of new content was halted for all practical purposes. In the four quarters from Q2 2020 - Q1 2021, with revenues soaring and cash costs collapsing, Netflix generated $2.5bn in FCF. The single best performance in the company’s history. KCR is glad we do not have a position in Netflix of any kind. We would love to hear the growth story for those contemplating the stock on the long side. We say that because Netflix is anything but a value play. To achieve even the most modest definition of that would require vastly higher FCFs. How high? To merely make it into the cheapest quintile of FCF/EV, a company needs a 7% FCF yield. For Netflix to simply qualify as a value stock today, that 7% would require they generate $8.8bn (signified by the green dot in the chart below) in FCF or 55x the trailing run-rate of $160ml. To summarize: Netflix is less expensive than before it plunged -60% but faces tremendous competition, sharp reductions in content and needs some sort of plausible growth narrative to justify its still bloated valuation. In last week’s piece we explained why we were dialing back our exposure to some of our staples stocks and gave the empirical evidence for investigating some of the market’s safest dividend stocks. In the table below we compare the basic fundamentals of Netflix with the Russell 1000 and our list of durable dividend stocks. Look at the numbers below. This is not complicated. As Buffett once said, “There is no award for degree of difficulty” and Netflix certainly looks difficult to us compared to our Durable Dividends. Conclusions: KCR believes that market inefficiency is at all-time highs Typical of the anatomy of a bear market, many investors are suffering from anchoring and “seeing” bargains in speculative stocks that have experienced price declines but are still expensive We believe today’s price dislocations create potent opportunities for patient investors who view equities as fractional ownership in actual operating YOU ARE NOW READING PREMIUM MEMBER LEVEL CONTENT PHN2ZyB3aWR0aD0iMzIiIGhlaWdodD0iMzIiIGZpbGw9Im5vbmUiIHhtbG5zPSJodHRwOi8vd3d3LnczLm9yZy8yMDAwL3N2ZyI+PHBhdGggY2xhc3M9InNpbmdsZV9fcGRmLWljb24tc3Ryb2tlIiBkPSJNMjAgMXY4aDgiIHN0cm9rZT0idmFyKC0tZzYpIiBzdHJva2Utd2lkdGg9IjIiIHN0cm9rZS1taXRlcmxpbWl0PSIxMCI+PC9wYXRoPjxwYXRoIGNsYXNzPSJzaW5nbGVfX3BkZi1pY29uLXN0cm9rZSIgZD0iTTI4IDEzVjlsLTgtOEg0djEyTTQgMjd2NGgyNHYtNCIgc3Ryb2tlPSJ2YXIoLS1nNikiIHN0cm9rZS13aWR0aD0iMiIgc3Ryb2tlLW1pdGVybGltaXQ9IjEwIiBzdHJva2UtbGluZWNhcD0ic3F1YXJlIj48L3BhdGg+PHBhdGggY2xhc3M9InNpbmdsZV9fcGRmLWljb24tZmlsbCIgZD0iTTEzLjE0MyAxOS4xMDVjMCAuNjM4LS4xODggMS4xMzEtLjU2NCAxLjQ3OS0uMzc2LjM0OC0uOTExLjUyMS0xLjYwNC41MjFoLS40MzRWMjNIOC45OTh2LTUuNzExaDEuOTc3Yy43MjEgMCAxLjI2My4xNTcgMS42MjUuNDczLjM2Mi4zMTYuNTQzLjc2Mi41NDMgMS4zNDN6bS0yLjYwMi43NDNoLjI4MWMuMjMyIDAgLjQxNi0uMDY1LjU1My0uMTk1LjEzNy0uMTMuMjA1LS4zMS4yMDUtLjUzOSAwLS4zODYtLjIxMy0uNTc4LS42NDEtLjU3OGgtLjM5OHYxLjMxMnpNMTguOSAyMC4wMjNjMCAuOTUzLS4yNjIgMS42ODgtLjc4NyAyLjIwMy0uNTI1LjUxNS0xLjI2Mi43NzQtMi4yMTMuNzc0aC0xLjg0OHYtNS43MTFoMS45NzdjLjkxNyAwIDEuNjI1LjIzNCAyLjEyMy43MDMuNDk4LjQ2OS43NDggMS4xNDYuNzQ4IDIuMDMxem0tMS42MDEuMDU1YzAtLjUyMy0uMTA0LS45MTEtLjMxMS0xLjE2NC0uMjA3LS4yNTMtLjUyMS0uMzc5LS45NDMtLjM3OWgtLjQ0OXYzLjE5OWguMzQ0Yy40NjkgMCAuODEyLS4xMzYgMS4wMzEtLjQwOC4yMTktLjI3Mi4zMjgtLjY4OC4zMjgtMS4yNDh6TTIxLjQ0MyAyM2gtMS41MnYtNS43MTFoMy4zNzV2MS4yMzhoLTEuODU1djEuMDloMS43MTF2MS4yMzhoLTEuNzFWMjN6IiBmaWxsPSJ2YXIoLS1nNikiPjwvcGF0aD48cGF0aCBjbGFzcz0ic2luZ2xlX19wZGYtaWNvbi1zdHJva2UiIGQ9Ik0zMSAxM0gxdjE0aDMwVjEzeiIgc3Ryb2tlPSJ2YXIoLS1nNikiIHN0cm9rZS13aWR0aD0iMiIgc3Ryb2tlLW1pdGVybGltaXQ9IjEwIiBzdHJva2UtbGluZWNhcD0ic3F1YXJlIj48L3BhdGg+PC9zdmc+Click here to download the Premium PDF https://kailashconcepts.com/wp-content/uploads/2021/11/icons8-vertical-line-50.pnghttps://kailashconcepts.com/wp-content/uploads/2021/11/icons8-lock-50.pngUpgrade your subscription now to unlock the full content Large cap for the purposes of this paper is defined as the Russell 1000 US Large Cap Index https://www.bloomberg.com/news/articles/2022-09-16/layoffs-spell-trouble-for-hollywood-as-netflix-warner-bros-cut-spending https://www.businessinsider.com/warner-bros-discovery-insiders-brace-layoffs-ad-sales-2022-9 https://www.npr.org/2022/06/24/1107360500/netflix-lays-off-several-hundred-more-employees As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade. If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you. KCR also offers a wide range of easy-to-use but sophisticated tools. Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias. L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded. The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra for anyone seeking out more information related to the topics above. Are Energy Stocks Undervalued S&P Energy ETF Disclaimer The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. 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