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Netflix: Red Flags Emerge In 10-Q Filing


Four red flags include: (1) deteriorating international contribution, (2) increase in international average revenue per member will slow growth, (3) cash burn is accelerating and (4) increased stock-based compensation.

In our view, the recent sell-off is in the early stages and the red flags indicate that Netflix's current valuation is unsustainable.

Our 12-month PT for NFLX is $65-$70, implying downside risk of 27%-32%.

NFLX Declines 14% in Past Week And Sell-Off May Be In Early Stages

Netflix (NASDAQ:NFLX) declined sharply following its Q1 earnings release last Monday and the stock is now down 14% over the past week. We expect the sell-off to continue throughout 2016 for several reasons and we maintain our one-year PT of $65-$70. Part I of our short thesis can be found here and Part II can be found here.

After reviewing the Form 10-Q that was filed on Wednesday, we found four red flags that indicate our short thesis remains intact and suggest the sell-off is in the early stages. These red flags include: (1) deteriorating international contribution loss, (2) international ARPU may begin to trend lower as pricing power appears to be overstated, (3) cash burn is accelerating and (4) stock-based compensation is on the rise.

Combined, these warning signs suggest Netflix likely reached a peak valuation in Q4 2015 when the stock traded as high as $133.27 per share and at a market capitalization of $57.1 billion. While Netflix remains the market leader and has vast opportunities in international expansion, we do not expect to see the valuation reach such an irrational and unsustainable level and we believe investors will appraise the company based on its reduced, moderate overall growth rate and more mature business model in a highly competitive market. In our view, with the stock currently trading at $95.90 per share or 340X projected 2016 EPS, there is 27%-32% downside risk for shareholders.


Red Flag #1: International Contribution Loss

In Q1 2016, Netflix reported an operating loss of $104.2 million compared to an operating loss of $65.0 million in the same period last year for its international business segment. While the company grew international streaming revenue at an impressive 56.9% for the quarter, cost of revenue soared at 67.8%. As a result, operating losses expanded to unprecedented levels despite management's efforts to lower operating expenses in the quarter. If management did not drastically scale back marketing and advertising spend in the quarter, the operating loss would have been even worse and likely would have approached -$125 million. We...