3 Reasons Netflix’s Stock Could Fall

Netflix, (ETR:NFC) has been one of the most hotly debated stocks in the market in the last 2 years. Based on the stock’s meteoric rise from less than $60 to nearly $500 during that time, it’s clear that Mr. Market sees great things happening at Netflix.

Indeed, the combination of domestic subscriber growth, higher revenue per user, and global expansion could catalyze further gains for Netflix investors. However, there are significant downside risks, too. Here are 3 important factors that could cause a sharp pullback for Netflix stock.

Domestic saturation

One big risk for Netflix investors is that as the company saturates the domestic streaming market, growth could suddenly slow at any time. As of last quarter, Netflix had 36.24 million domestic streaming subscribers: up about 22% year-over-year. Recently, Netflix has been growing its domestic streaming subscriber base at a fairly steady rate of about 6.5 million annually.

At this pace, more than half of the roughly 90 million broadband households in the U.S. will subscribe to Netflix by the end of next year. Other, smaller streaming services like Hulu andAmazon.com’s Prime Instant Video will account for a significant chunk of the remaining broadband households.

At some point, there won’t be enough non-subscribers left in the U.S. for Netflix to maintain its growth pace. Netflix stock currently trades at an astonishingly high multiple of more than 100 times expected 2014 earnings. A sharp slowdown in domestic growth could cause investors to think twice about Netflix’s valuation, leading to sharp multiple contraction.

Long road to international profitability

Netflix bulls might argue that even if domestic growth is bound to moderate at some point in the next few years, Netflix can rely on international expansion to power its growth. It’s true that international markets could provide years of rapid revenue growth.

However, investors are ultimately interested in profit, not just revenue. On this score, it’s less clear how helpful international expansion will be. Last week, Netflix CEO Reed Hastings stated that he expects Netflix to become profitable in Europe — where it recently embarked on anambitious expansion project — within 5-10 years.

Given that Europe now makes up well over half of Netflix’s international addressable market (based on the number of broadband households), this is a discouraging estimate. As long as Netflix is unprofitable in Europe, its international operations more broadly are unlikely to turn a profit.

It’s quite possible that Reed Hastings is trying to dampen investor enthusiasm by exaggerating how long it will take to make money in Europe. Still, investors shouldn’t ignore the possibility that Hastings is telling the truth, and international profits are still 5-10 years away.

The DVD business is dying

A third potential problem for Netflix stock is that the company’s DVD business is fading away. This isn’t very surprising, given the advantages of streaming over DVD-by-mail. However, the DVD division’s contribution to overall profitability can easily be missed due to the prominence of Netflix’s streaming business.

In fact, the DVD business posted a $93 million operating profit last quarter, which accounted for 79% of Netflix’s total pre-tax profit. DVD revenue and profit has been falling at a double-digit annual rate recently, and the loss of this income will have a significant impact on Netflix’s earnings power.

If Netflix can quickly grow its streaming earnings, then investors will hardly notice the decline of the DVD segment. On the other hand, if domestic growth hits a wall within the next few years and the international segment continues losing money, then falling DVD earnings could be painful indeed.

Too hot to handle

Netflix has posted strong revenue and earnings growth recently and it has a huge international growth opportunity. That said, its shares trade for more than 100 times projected 2014 earnings and Netflix faces a variety of potential stumbling blocks in the coming years.

Netflix CEO Reed Hastings has warned that it could take 5-10 years for Netflix to turn profitable in Europe. On the home front, Netflix’s streaming business could start to saturate the U.S. market within the next few years, leading to slower growth beyond then. Meanwhile, Netflix’s DVD business — which is still quite profitable — is inexorably declining.

These factors could combine to create a “perfect storm” where future earnings growth is much slower than what most investors currently expect. This risk may be reason enough to stay away from Netflix stock at its current elevated valuation.