Has the Short Thesis on Netflix Been Put to Rest?

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Netflix remains firmly in the good graces of investors and the market, but its remaining naysayers may have valid points as to why you should approach cautiously. Premium investor service SumZero recently published a short thesis on the company suggesting that a common complaint -- content costs -- would bring the stock much lower than its current levels. Since then, Netflix announced a price hike to compensate for rising costs. Does this alleviate the last few concerns that Netflix may not reach the stratospheric levels that most investors are betting on?

The pitch
David Trainer of Novo Capital Management, the author of the short thesis on Netflix, cites facts such as the five-year NOPAT (net operating profit after tax) CAGR of just 4%. That may come as a surprise, considering the market's exuberant reaction to the last year's worth of earnings announcements, but the company was coming off poor performance and just recently topped its 2009 NOPAT levels. Still, as the entire market is aware, revenue is climbing fast as the company tacks on subscribers at an incredible rate. There is no doubt that the demand for Netflix's service is tremendous (with the exception of the DVD mail business, which is on its way out the door).

The topic of content costs is a burden shared by every distributor on the planet, so it isn't exclusively Netflix's problem, but the result of the company's race to grow subscribers and revenue at a faster rate than its costs is yet to be determined. With more and more competition mounting up against the streaming leader, the bidding wars will only get more intense. Netflix is thus faced with the question of which lever to pull to boost its sales and margins.

As we now know, the company has illuminated its thinking on the subject (giving credence to Trainer's thoughts) and decided to pull the unit-level profitability measure. Instead of trying to sign up all of Earth to Netflix right now, the company will accept what is likely to be a somewhat lower rate of subscriber growth and boost its prices to new members by 20%.

Does this move take the wind out of the shorts' sails? The market thinks the price hike is the right move, as the stock rose more on this news than after the recent earnings report that showed nearly all financials in line with estimates. The company did outperform on subscriber gains, hitting 4 million in the quarter. Unless subscriber growth takes a dive, the $1 to $2 extra per person should give the company the breathing room it needs to stomach the content cost issue.

Evidence is mixed on what will happen with a mass rollout of price increases. The company recently raised prices in Ireland and noted a minimal impact on growth rates. Yet as many remember back in 2011, management attempted a 60% price hike of its combo package (DVD and streaming) and subscribers fled the scene.

The latter story is unlikely to happen again. For one thing, Netflix has increased its value in the eye of its customers with the rollout of top-tier original content (arguably its best move in the company's history). Most would agree that paying $8.99 per month for the substantial catalogue is a price between cheap and reasonable. Even at $10 per month, this is a value-priced offering that competes handily with the much more expensive traditional content providers.

Though Trainer's analysis was accurate at the time of publishing, it appears that his (and the majority of shorts') theses are being pressed further down by Netflix's recent developments. The stock is exorbitantly expensive and doesn't appeal to fundamentals-heavy, price-conscious investors, but it was never supposed to. For those willing to take the ride, the company undoubtedly has a compelling path ahead of it.

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The article Has the Short Thesis on Netflix Been Put to Rest? originally appeared on Fool.com.

Michael Lewis has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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