The Stock

The Trade: Netflix (NSDQ: NFLX)–Short > 60.

Why Now: Increased competition from deep-pocketed rivals such as Amazon.com (NSDQ: AMZN) and slowing subscription growth will continue to weigh on shares of Netflix (NSDQ: NFLX).

The Story

On an Amtrak Acela train bound for Washington, DC, Elliott enjoys a coffee while revisiting his notes from the National Association of Publicly Traded Partnership’s (NAPTP) Master Limited Partnership (MLP) Investor Conference in Greenwich, Conn. The strains of Greece’s national anthem disrupt his reverie, which can only mean one thing: a phone call from Yiannis.

Elliott: Hello?

Yiannis: Where are we eating lunch?

Elliott: Get with the program. I’ve been at the NAPTP MLP Investor conference all week and won’t be back in town until 7:30 pm. If you don’t mind waiting six hours, we can meet for lunch.

Yiannis: We need to discuss the June issue of Cocktail Stocks. Do you have any ideas for this month’s pick?

Elliott: Nothing concrete. We’ve warned for some time that the stock market would likely suffer a summer swoon for the third consecutive year. Although US equities have pulled back in recent weeks, investors should be prepared for additional downside. Our short bet against Best Buy (NYSE: BBY) has returned more than 20 percent since we highlighted the play on March 7. With the EU sovereign-debt crisis sparking another flight to safety, I’m inclined to short another company that’s fighting a losing battle against structural headwinds.

Yiannis: You get any ideas from the MLP conference?

Elliott: The mood in Greenwich was relatively upbeat, as many energy-focused MLPs have little exposure to commodity prices or the economy. Truth be told, the recent downturn is a blessing for investors, who can now pick up many of my favorite MLPs at favorable prices.

I see further downside in store for the US stock market and would wait until later this summer to start deploying any dry powder. I’d sell the rallies and confine your stock purchases to MLPs and other defensive names.

Yiannis: Trade or fade for this month’s pick?

Elliott: Fade!

Yiannis: In that case, I have an investment idea.

Elliott: The suspense is killing me.

Yiannis: Let’s save it for our late lunch. I assumed we’ll eat at either La Bergerie or Jackson 20?

Elliott: We need to break you out of your comfort zone; let’s try something different this time.

Yiannis: You can try experiment on your own time. I only eat at La Bergerie or Jackson 20 when I’m in Alexandria, Va.

Elliott: You also once told me that you always use a five iron on the first tee. How has that worked out for you? The last time we hit the links, one of your five-iron drives made it all the way to the ladies’ tee!

Yiannis: I don’t know what you’re talking about.

Elliott: Ha. I’ll meet you at Vermillion on the Saturday before the issue goes out.  

Yiannis: I’ll see you there. Where are we going to eat?

Elliott: I’ll sort out the meal. Make sure you’re ready to discuss your investment idea.

Yiannis strolls into Vermillion and spots Elliott at the bar.

Yiannis: What’s up?  

Elliott: Drinking a split of Louis Roederer Brut Premier. You want the same?

Yiannis: Please.

Before Yiannis can blink, he has a glass of champagne in his hand.

Yiannis: Impressive service. Are we eating here?

Elliott: I often come here for the late-night menu on my way home from my office. I’ve never had a bad meal here, but there’s a live band tonight. Let’s get some seafood at Hank’s Oyster Bar after we have a few drinks here.

Yiannis: Works for me, I guess. You sure you don’t want to go to La Bergerie or Jackson 20?

Elliott: Expand your horizons, Yiannis. What’s your idea for this month’s issue?

Yiannis: I think we should short Netflix (NSDQ: NFLX), the company that offers unlimited streaming TV shows and movies delivered over the Internet for a monthly fee. The company also delivers DVDs and Blu-ray Discs to subscribers via mail.

Elliott: I’m familiar with Netflix; in fact, I used to be a subscriber.

Yiannis: In that case, you’re probably familiar with the challenges that Netflix faces. Not only must the company struggle intensifying competition from rivals that offer similar services, but subscription sales will also tail off as the market matures. And Netflix’s international operations have yet to contribute meaningful revenue growth.

Elliott: The emergence of other options for streaming video prompted me to cancel my Netflix subscription. Cable provider Comcast Corp (NSDQ: CMCSA) offers on-demand TV shows for free, and you can rent movies directly through the cable box. I don’t have time to watch more than a movie or two each month and only catch a few TV shows–unless you count having CNBC on in the background. And Netflix isn’t the only service that’s offers unlimited streaming video.

Yiannis: I recall you mentioning that your Amazon.com (NSDQ: AMZN) Prime account includes free streaming movies and TV shows.

Elliott: You’re right. My Prime membership costs me $79 a year and includes free two-day shipping on all orders fulfilled by Amazon.com. The free streaming videos are a bonus. That reminds me, you still owe me $20 for the last order I placed for you.

Yiannis: Netflix enjoyed a distinct advantage over would-be competitors in the early years because of its network of distribution centers and mailing facilities to manage the distribution and return of DVDs. But with Netflix subscribers increasingly shunning DVDs and Blu-ray Discs for content delivered instantly via the Internet, the firm’s much vaunted distribution chain has lost value. The shift online opens the door for almost any company with an online presence to compete with Netflix, including the big heavyweights such as Apple and Amazon.com. Both of these competitors sport market capitalizations that dwarf Netflix.

Yiannis: Earlier this year, Verizon Communications (NYSE: VZ) and Coinstar (NSDQ: CSTR), which operates the Redbox DVD and Blu-ray Disc rental kiosks, announced a plan to launch a subscription-based movie service that will offer DVDs, Blu-ray Discs and streaming video. Slated to launch in the second half of 2012, this joint venture could exert further pressure on Netflix’s pricing power.

Elliott: Let’s head over to Hank’s Oyster Bar. I need some dinner before I kick the tires on your investment thesis. I’ll add the cost of your champagne split to the $20 you already owe me for you last order from Amazon.com.

Elliott and Yiannis walk two blocks to Hank’s Oyster Bar. After sitting down, Elliott orders a bottle of the 2010 Sancerre Moulin de Vrilleres. The waitress informs them that the kitchen closes at 9:30 pm.

Yiannis: For the record, I said we should go to La Bergerie. Now I’ll have to rush my order.

Elliott: Don’t you live in McLean, where everything closes at 7:30 pm? What are you complaining about?

Thirty minutes later, Elliott and Yiannis tuck in to a spread of two dozen oysters on the half shell, two orders of peel-and-eat shrimp, roasted Brussels Sprouts, lobster rolls, two plates of fries and a whole trout in a white wine, lemon and butter sauce. 

Elliott: Will two orders of fries be enough for you? We might be able to sneak in a third plate if you order now.

Yiannis: Very funny.

Elliott: Anyway, let’s get back to Netflix. Investors who are bullish on the stock would argue that the company locked up popular content before its rivals saw the potential in streaming online video. Few can compete with this deep library of titles.

Yiannis: The expiration of these deals and rising licensing costs represent a major challenge to Netflix.

In 2008 Netflix inked a content licensing deal with Starz Entertainment that covered the cable network’s original programming and movies for which the firm owned the broadcast rights. Although neither side has disclosed the terms of this deal, industry reports peg the cost at about $30 million per year.

Four years ago, video streaming was in its infancy; today, Netflix has more than 23 million domestic and about 3 million international subscribers. Starz Entertainment recently rebuffed Netflix’s reported offer of $200 million to $300 per year to extend the previous licensing agreement. That’s 10 times the original price.

Elliott: And content is king.

Yiannis: Netflix needs popular content to attract subscribers and compete with Amazon.com. Management had hoped that revenue growth from new subscribers would outpace the cost of securing content. First-quarter results suggest that this plan may not work.

With the restaurant beginning to clear out, Elliott and Yiannis turn their attention to the feast on their table.

Elliott: You up for an after-dinner drink?

Yiannis: I know the perfect place: Taverna Cretekou.

Elliot: Don’t they close at 10:30? I think we might be out of luck.

Yiannis: Don’t worry about it, Malaka.

The lights are off in Taverna Cretekou, and the door is locked. Yiannis walks down an alley to the back patio and begins yammering away in Greek. Ten minutes later, the restaurant owner sets up a table on the patio. A waiter brings Elliott and Yiannis a bottle of wine and two small bottles of sparkling water. 

Elliott: Impressive.

Yiannis: I told you, malaka.

Elliott: I’m on board with shorting Netflix. The company is pouring money into efforts to expand their overseas business. In addition to expenses associated with securing content, Netflix is also spending heavily on marketing. This strategy hinges on the domestic business generating enough cash flow to pursue international opportunities. Any weakness in Netflix’s US-based operations could force the company to slow its expansion efforts. To date, the overseas business hasn’t reached a point that would offset subpar revenue growth at home.

Yiannis: Some analysts estimate that subscriber growth will fall to 8.6 percent in the second quarter of 2012 from 63.9 percent in the second quarter of 2011. Such a slowdown could prompt a significant selloff; the stock currently trades at more than 30 times forward earnings. 

Elliott: I have one concern with shorting Netflix: Heavy betting against the stock could lead to the occasional short squeeze. Some brokers may also have problems borrowing the shares for a short play.

Yiannis: Short bets make up about 20 percent of Netflix’s float, but that’s been the case for some time and the stock has continued to trend lower.

Elliott: Good point. Investors should sell short Netflix when the stock trades above 60. For investors whose brokers can’t borrow shares of Netflix, Best Buy should be shorted above 17.50. (See Brick-and-Mortar Bust.)

Yiannis: I have some other good news for you: I paid the bill in advance when I talked to the owner. That should more than make up for earlier.

Elliott: Perfect.

Updates on Open Trades

August 2010: Vale (NYSE: VALE)–Buy < 25

Iron ore prices have held up, but worries about an economic slowdown in China have weighed on stock prices in the industry. At these levels, Vale’s valuation anticipates that iron ore will decline to $100 per metric tonne. Nevertheless, the Brazil-based mining giant’s long-term growth story remains intact, though iron ore prices will drive the stock in the near term.

September 2010: Teekay Tankers (NYSE: TNK)–Buy < 7

A 16.6 percent yield is Teekay Tankers’ only saving grace. We’ve been in this trade long enough that all the bad news has been priced into the stock–including lower day-rates on the spot market in 2012. The stock has a ways to go for us to break even.

February 2011: ProShares UltraShort 20+ Year Treasury (NYSE: TBT)–Buy < 25

Betting against US Treasury notes has been a losing proposition. This position could recover some lost ground when investors eventually rotate funds from safe havens to equities.

June 2011: iShares MSCI Italy Index (NYSE: EWI)0–Buy < 15

This play on Europe’s turnaround is less risky than our Greece-related bet. The Italians are progressing well under the leadership of their technocratic government, though improving confidence in the EU’s ability to resolve the ongoing debt crisis would help. The exchange-traded fund also offers a 5.5 percent dividend yield.

July 2011: TransGlobe Energy Corp (NSDQ: TGA)–Buy < 15

Shares of this small-cap oil producer have posted solid gains in 2012. The recent weakness reflects the drop in oil prices. This speculative stock will outperform in bull markets and underperform in bear markets.

July 2011: Market Vectors Gulf States Index (NYSE: MES)–Buy < 23.50

This exchange-traded fund (ETF) has held its own since we featured it in July 2011. That being said, the ETF is flat this year. We’re holding out for a powerful upsurge.

August 2011: National Bank of Greece (NYSE: NBG)–Buy < USD3

This stock is our most speculative play to date and is only appropriate for aggressive investors who can stomach a bet that’s based solely on a turnaround in Greece. Any orderly resolution to Greece’s sovereign-debt crisis could send the stock price higher in a hurry.

September 2011: China Cord Blood Corp (NYSE: CO)–Buy < 4

Don’t let near-term volatility shake you out of this stock. Shares of China Cord Blood Corp are down marginally this year. Recently the private-equity firm KKR & Co. LP (NYSE: KKR) purchased USD65 million worth of convertible notes issued by China Cord Blood. Expect more upside as the industry’s fundamentals turn.

October 2011: Infosys (NSDQ: INFY)–Buy < 50

A slower mover than other technology stocks, shares of Infosys should keep pace with India’s stock market, which has been pounded this year. Investors should adhere to our buy target.

December 2011: Symantec Corp (NSDQ: SYMC)–Buy < 18

Internet security is a major growth market, and Symantec should continue to benefit. The stock seems to have found support at current levels. Investors should adhere to our buy target.

February 2012: Greenbrier Companies (NYSE: GBX)–Buy < 20

This stock has sold off since we profiled it in February, but the company’s underlying growth story remains intact. Improving US economic data would give the shares a boost.

March 2012: Best Buy (NYSE: BBY)–Sell Short > 17.50

Recent results have disappointed, and we don’t expect the recent CEO change to make a difference for the retailer. The stock has bounced of late, but further downside is possible. Stay short.

April 2012: AU Optronics (NYSE: AUO)–Buy < 5

The stock has pulled back in price because of weakness in the broader market. We remain confident in the company’s turnaround story. Rising LCD panel prices will also help.

Management recently noted that the company’s losses are narrowing at a faster-than-expected pace. If demand keeps up, we may see shortages of LCD panels by September. AU Optronics remains a turnaround play with solid upside.

May 2012: Roundy’s (NYSE: RNDY)–Buy < 12.50

Management indicated that 2012 sales growth would be lower than expected, and the market sold the stock. At the same time, the initiation of a quarterly dividend could offset some of this weakness.