Showtime for Netflix?

As part of ongoing portfolio evaluation process, I often ask myself a question: Which company has the highest potential in the next decade?  The answer may surprise you: I think it is Netflix.

Netflix stock had a wild ride over the last couple of years.  After reaching a high of around $300 in the summer of 2011, it fell all the way to $60 as a result of several company-specific missteps, most notably the Qwikster fiasco.  As of this writing, however, it has recovered all these losses and then some, and once again Netflix trades at all time high.  So what are opportunities and pitfalls for Netflix going forward?

Let’s start with the positives:

– International presence.  Today, Netflix has about 10 million international customers compared to 30 million domestic, where it derives most of its revenue. But it will not always be that way.  An established internet-based company, such as Amazon, can be expected to derive up to 80% of revenues from overseas.  Even after recent expansion, Netflix international presence is still minuscule, and it has an enormous potential ahead overseas.

– Revenue.  Netflix hasn’t raised prices since above-mentioned Qwikster debacle, but it won’t charge $7.99 per month forever.  When it raises prices by a buck or two, I don’t think many subscribers will defect.  And the increase will flow directly to profits, potentially doubling or tripling them overnight.

– Stock price.  Psychologically, it may be difficult to buy a stock that rose 5x during the previous year.  However, if, as long-term investors, we overlook the recent stock gyrations, Netflix trades just a bit higher than it was in summer of 2011, more than two years ago.

And here are some challenges:

– While international operations are becoming more efficient, Netflix is still not profitable overseas.

– The internet based TV is still in its infancy, and Netflix model could be disrupted by a yet unknown entrant in the industry.

– Stock valuation is quite high, on the level of other “momentum” stocks such as LinkedIn, Zillow, and Tesla.

Without a doubt, Netflix stock is risky, and yet it presents a very compelling growth potential over the next several years.

Apple and Baidu Revisited

In my previous post back in April, I wrote about underwhelming performance of Apple and Baidu, especially in light of rising markets.  Now is a good time to revisit where these companies stand now.

Let’s start with Baidu, also known as Google of China.  For nearly a year, investors were highly skeptical of its ability to monetize mobile search and were concerned with slight market share loss in search to competitor Qihoo.  Its reasonable valuation, high growth rate and dominant market position were all discounted.  However, market perception can change quickly.  Baidu reported good progress in its mobile business, and suddenly the market realized that this discounting was unwarranted.  As a result, stock rose about 70% from its bottom.

Apple stock started its downtrend about a year ago, due to increased competition, margin pressure, and perceived lack of innovation.  It did bounce up 25% from its bottom, but even today its valuation metrics are still lower compared to such “innovative” companies as Microsoft or Intel.  Today’s introduction of iPhone 5C and iPhone 5S did not reveal anything revolutionary, but that is becoming more difficult as product categories mature.  Apple still remains a cash generation machine, and has an enviable problem of what to do with all that cash on the books.  Activist and hedge fund manager Carl Icahn sees a value here and argues for return of that cash to shareholders via even larger dividends and stock buybacks.

Patience is definitely a virtue in investing.  Recognizing a quality stock out of favor, such as Apple and Baidu in the spring, often leads to supersized returns.  Even after its bounce back from the lows, Apple remains quite attractive today.   As to other quality companies out of favor today, consider Panera Bread and Intuitive Surgical.

Musings on Apple and Baidu

Despite overall market strong performance over the last two quarters, there are some noteworthy companies that not only didn’t participate in the rally, but suffered significant declines just as the markets were hitting new highs.  Apple and Baidu crushed the market over the last several years, but both suffered nearly 40% declines from their peak.

After reaching its peak last September, Apple price was pushed down by fears of increased competition, margin pressures, and perceived lack of new innovation. While the first two issues have some merit, I don’t think that they can possibly account for the valuation assigned to Apple these days — on the PE basis, it trades lower than technology stalwarts such as Microsoft or Intel, but still growing considerably faster. As for lack of innovation — even under Steve Jobs, there were only three major innovations: 2001 (iPod), 2007 (iPhone) and 2010 (iPad). There were no new disruptive products introduced for 6 years between 2001 and 2007, and many (myself included) in 2010 thought that the new iPad was just a big iPhone without calling capability. Market perception can and does change quite often: for example, Netflix, the best performer during this quarter, was universally hated last summer and traded at about a third of its current price. While it is highly unlikely that Apple can triple its price from here, at least reaching its prior highs is a good possibility. A number of fairly likely events in the near future, such as raising dividend, striking a deal with China Mobile, or introducing new products, could act as a catalyst for price appreciation.

Baidu, also known as Google of China, fell out of grace due to competition, slowing growth, and perceived difficulties in monetizing mobile search. While the revenue growth did slow down about 30% per year, it is still very respectable. Baidu is growing much faster than Google, yet trades at lower multiples. If you recall, Google itself was criticized for poor mobile revenues, and in fact, Google stock price was stuck in a trading range for several years before finally breaking out last fall.

The last several months were extremely frustrating for Apple and Baidu shareholders as they watched stock prices trade at yearly lows just as overall market was making new highs.  However, I think that patient investors will be rewarded for placing their faith in these world class companies.

Is It Time to ‘Like’ Facebook?

After a pompous IPO back in May, investors definitely did not like Facebook the stock, and the price has been steadily dropping ever since, reaching all-time low at nearly 50% below the offering price.  So, is it time to finally ‘like’ the stock?

There are many arguments against that.  Here’s the rundown:

• Valuation.  Even after the drop, the valuation relative to most other Internet names remains expensive.  Facebook forward P/E ratio is still high at 30, while P/S (price to sales) is at 10.  Compare that to Google’s forward P/E of 14 and P/S of 5 – and that’s a fair comparison, since Google and Facebook projected growth rates are fairly similar.
• Lockup Expiration.  Facebook has over 2 billion shares outstanding, but only about one billion float.  The difference is currently in lockup period — early investors and employees own the stock, but will be only able to sell after lockup period expires in several tranches.  The first tranche of 217 million shares became available to trade this week, and obligingly the stock declined.  But by far the largest chunk of shares, about 1 billion, will be available to trade on November 14, creating very heavy selling pressure on the shares.
• Taxes.  With all the talk about fiscal cliff, there is uncertainty about tax rules next year.  There is a good possibility that capital gains tax rate will be higher in 2013.  So all these early investors may be tempted to sell this year to lock in favorable tax rates, creating selling pressure at year end.
• Taxes – again.  Those unfortunate investors who bought near IPO prices may want to sell their shares this year to harvest capital losses, yet again creating selling pressure.

Taking a longer-term view, however, Facebook is certainly a unique company.  Very few companies can boast nearly a billion customers, and there is no real competition (Google+ being very far behind).  The trick, of course, is to figure out how to effectively monetize all those customers, and you can be assured that Facebook management is concentrating on that right now.  Netflix chief Reed Hastings who is on Facebook board and billionaire investor George Soros subscribe to that view: they recently bought $1 million and $10 million worth of Facebook stock, respectively (both are now down slightly in these positions).

My view is that aggressive investors may want to establish a small starting position now.  However, heavy headwinds this year as described above will probably make you like Facebook stock price much better later this year (unless you already own it, of course).

More on Netflix

Well, the last three months certainly have been eventful for Netflix.  As of now, the stock is only worth about a quarter of what it fetched back in July.  The latest nail was struck after the quarterly report when the company warned that it might be unprofitable in 2012 due to the costs of international expansion.  Reed Hastings went from the being the smartest CEO to apparently the dumbest.  A number of articles appeared in financial press claiming that Netflix streaming model is unsustainable and predicting company bankruptcy (!) within a year.

Without a doubt, PR around recent price hike and the whole Qwikster debacle could have been handled better.  But what has really changed?  The 800,000 subscribers lost during the last quarter is a big number — but Netflix still has 24 million subscribers who apparently value the service even after the price increase.  Starz decided not to renew its streaming deal, but Netflix signed up a number of other studios instead.  Finally, Netflix could show good profits next year, but instead it chose to use the funds to invest in growing the business by international expansion.  Does all of this really deserve 75% haircut?

Well, of course it is debatable whether $300 price tag was justified in the first place.  Looking back at stock price history, a very similar drop happened before, back in 2004.  Then, Netflix had to lower prices to fend off Blockbuster’s Total Access program, and the stock promptly tanked from over $40 to just below $10 — a 75% drop.  For 5 years after that, the stock price was stuck in a trading range between 15 and 30, and it took off with a vengeance in 2009.

I believe that we could be in for a similar trading range for the next several years.  Currently, the stock is cheap based on fundamentals, such as price-to-sales ratio.  Also, any number of cash-rich companies, for example, Amazon, Apple, Microsoft, Google, etc. could acquire the company with minimal impact on their cash position.  This should provide support for the stock.  On the other hand, I don’t see any catalysts to propel the stock forward in the near future.  The prospect of unprofitable 2012 will certainly make short-term oriented Wall Street analysts to talk down the stock and this will put a lid on meaningful appreciation.

Can Netflix reach $300 again?  I think it is very possible, if the company can still attract U.S. subscribers and if it is successful in its international expansion.  I think that current price levels present an excellent opportunity to long-term oriented and patient investors.

Netflix Splits: Brilliant or Moronic?

The last two months were not good to Netflix shareholders.  After peaking at over $300 in July, the stock has been in free-fall and by the time of this writing, lost more than 50% of its value.  So what happened?

In July, Netflix announced a significant price hike, which understandably was not taken favorably by its customers. In early September, Starz decided not to renew its streaming contract with Netflix.  Then, later this month Netflix cut its guidance for subscribers in the U.S. by 600,000 (Netflix currently has about 25 million subscribers).  Finally, yesterday, Netflix CEO Reed Hastings in his blog apologized for not communicating clearly the reasons for price increase.  He also stated that streaming and DVD-by-mail operations will be split into two separate entities, with rather uninspiring name Qwikster for its DVD-by-mail operation. Netflix name will be reserved for streaming.

The reaction to the split was quite negative.  Indeed, the two entities will be completely separated, and so customers will have to look for movies on two different websites.  Also, giving up brand name of Netflix doesn’t sound thoughtful.  It appears that Netflix managed to shoot itself in the foot at least twice during the last couple of months.  Did the management lose its touch?

From the current reaction of many customers and from looking at the stock prices, it certainly appears so.  But taking a longer-term view, I think that Reed Hastings made a bold and correct strategic decision.  It is clear that the future is in streaming and so new Netflix can stay focused on it.  It also clear that DVD-by-mail business has peaked and will start declining.  It would be much better that the brand name of Netflix will not then be associated with a dying business.

Despite backlash from subscribers, Netflix still provides the best value.  As a case study, my family pays over $100 per month to Comcast cable and about $20 to Netflix.  I would estimate that we watch Netflix 80-90% of the time.

If someone cancels their DVD-by-mail service, where would they go?  Video stores are almost non-existent anymore.  There is Redbox, but their selection is extremely limited.  Netflix (soon Qwikster) has nearly every title available.

If someone cancels their streaming service, where would they go?  Despite its limited streaming library, Netflix is by far the more comprehensive choice among other options, such as Amazon or Hulu.  Almost every DVD player and many TVs now have Netflix player built-in.  Yes, it is easy for some of us to connect a computer to the TV, but in reality most people do not want this hassle.  You can of course buy pay-per-view movies, but just two of them will cost more than a whole month of Netflix subscription.

In this blog, Reed Hastings wrote:

For the past five years, my greatest fear at Netflix has been that we wouldn’t make the leap from success in DVDs to success in streaming. Most companies that are great at something – like AOL dialup or Borders bookstores – do not become great at new things people want (streaming for us) because they are afraid to hurt their initial business. Eventually these companies realize their error of not focusing enough on the new thing, and then the company fights desperately and hopelessly to recover. Companies rarely die from moving too fast, and they frequently die from moving too slowly.

The split may look moronic today, but it could well prove to be brilliant in the future.

Now, what about stock price?  Sudden and sharp declines of 50% or more are quite common for high growth stocks.  It happened to Netflix before, and it happened to most other growers – such as Amazon, Walmart, and Apple.  While in the short term Netflix stock will continue to be volatile and it may see $100 before it sees $300 again, longer term performance will, as always, depend on company execution.  So far, I have full faith in Netflix management.

Seismic Shift in the Chip Industry

As is normally is the case, this year’s Computer Electronics Show (CES) in Las Vegas featured a slew of new product announcements and demonstrations.  But I think that Nvidia stole the show.

First, some background.  Nvidia is best known as a graphics chip manufacturer, and, together with ATI, they effectively control mid and high-end GPU  (graphics processing unit) market.  Intel has a significant share of the low end of that space.  Of course, Intel completely dominates x86 CPU (central processing unit) market, with AMD being a very distant second.

Several years ago, AMD acquired ATI (which almost lead to the demise of the company, but that’s another story), and started working on project Fusion, which goal is to bring the functions of CPU and GPU on a single chip, thus eliminating the need of a separate GPU altogether.  Intel also has solutions of its own in the low end, and it has been working to improve the graphics portion of its solution as well.  There were rumors that Nvidia may enter x86 CPU market, but the company stated that it has no interest to compete with Intel on its own turf.  As a result, Nvidia found itself to be in the difficult position of having GPU solution only, without any CPU exposure.   Many speculated that this would lead to the company being acquired in the best case, and to its demise in the worst.

The last two years were difficult for Nvidia, but it has been working to two fronts.  On the high end, it introduced supercomputing product Tesla, based on its GPU technology.  GPU chips are actually considerably more complicated and powerful than x86 chips, but so far have been only used for graphics applications.  Tesla product changed that and now Tesla-based supercomputers run circles around ones based on the x86 architecture.

On the low end, Nvidia introduced Tegra, a chip intended for smartphones and tablets.  Its adoption was slow at first, but at CES, dozens of manufacturers, such as Motorola, LG, Samsung and many others, announced new products based on Tegra chips.   It looks increasingly likely that Nvidia is set to control a high share of Android-based smartphone and tablet processors.  With only limited success in mobile space, Intel now finds itself surrounded by Nvidia from the low and high ends.

But the real bombshell was delivered at the end of the show.  Nvidia unveiled project Denver, its answer to AMD’s Fusion and Intel’s CPU/GPU integration.  Nvidia stayed true to its unwillingness to enter x86 market; indeed, x86 architecture is now quite dated.  Instead, Nvidia is basing its general purpose CPU on ARM chip, which is a newer design and has a number of advantages, such as low power consumption and better efficiency.  Also, rather than taking an old x86 chip and adding on considerably more complex GPU, as AMD and Intel are doing, Nvidia is taking the opposite approach — it starts with a GPU design in which in has unquestionable expertise and adds a considerably less complex CPU part to it.  This just makes a lot more sense.

But who needs a new chip for laptops and desktops?  That same day, Microsoft announced that it is going to port its upcoming Windows 8 to the new ARM architecture.  In other words, x86 monopoly on CPU is over.

Now, suddenly Intel finds itself in a difficult position.  Over the years, it has tried, and failed, to produce its own mid and high end graphics solution.  So it needs Nvidia to supply GPUs for their products.  Nvidia, however, no longer needs Intel.  In fact, the next day Intel and Nvidia announced the end of their patent disputes, and Intel is paying $1.5 billion to Nvidia for the right to use their patents.  That’s not chump change; it will go a long way for Nvidia to help fund its development of their new chip.  But the biggest loser in all of this is AMD — in fact, that same day its CEO was effectively fired by the board.  Its project Fusion only had a limited success and AMD has no presence whatsoever in the mobile space.

I think the events of the last few days mark a seismic shift in the chip industry.  While new Nvidia’s chip is still more than a year away, Intel dominance of the CPU market is likely over.  With popularity of Apple products and Android-based devices, Wintel days are numbered as well.  Nvidia can now effectively compete with Intel on the full computing spectrum.  Next several years will be very interesting.

Sky-High in the Cloud

Cloud computing is all the rage these days.  There is a huge investor demand for the shares of market leaders in the space, and as a result their valuations are sky-high.  According to Yahoo!, VMware (VMW) sports a trailing P/E ratio of 115.  Salesforce.com (CRM) trades at 205.  Rackspace Hosting (RAX) is a relative bargain at P/E of 97.  These valuations are right in line with those of many high-tech stocks during happy bubble days of late 90’s and early 2000.  This is a cause for worry.

The good news is, that unlike 2000, these exuberant price levels do not affect the whole market.  In 2000, S&P 500 P/E was pushing 50.  Nowadays, overall market is very reasonably valued, and that includes most of high-tech stocks.  Even market darlings with triple-digit prices, such as Apple (AAPL) and Google (GOOG) have very reasonable valuations.

Cloud computing is indeed at the forefront of technology today, and one could argue that the market leaders in that space deserve premium pricing.  Yet, as history has shown us many times, current valuations are simply not sustainable.  Sooner or later, as it always happens, prices will reflect the fundamentals.  It could take some time, and so I would not make aggressive bets against these stocks, such as shorting or buying puts.  As John Maynard Keynes said, “Markets can remain irrational a lot longer than you and I can remain solvent”.  But eventually they will get rational.  Buyer beware.

More Earnings

As the earnings season draws to a close, more companies reported their earnings the last few days.  Among the companies that I follow, Nvidia (NVDA), Activision (ATVI), Marvel Entertainment (MVL), Akamai (AKAM), Buffalo Wild Wings (BWLD) beat expectations, while Garmin (GRMN) and Blackboard (BBBB) fell short.

Overall, this earnings season turns out to be significantly tamer than many feared.

Best Buy Helps the Market

Today, electronics retailer Best Buy reported a drop in its profits, but at the same time provided guidance that exceeded Wall Streets estimates.  As a result, its stock rose substantially and contributed to the advance in the overall market.  The fact that Best Buy sells consumer discretionary goods and its better outlook indicates that consumer spending decline is at least moderating.