Netflix Stock: Ackman Made An Error But You Can Gain (NASDAQ:NFLX)

Hedge fund investor Bill Ackman has been forced into an embarrassing U-turn on a huge chunk of Netflix (NASDAQ:NFLX) stock which he only bought in January. Around that time, I warned that the stock had further to fall and predicted that $250 was possible. In this article, I will discuss the next path for the stock.

Bill Ackman’s Market Timing On Netflix Was Poor

On January 23rd, I published an article on Seeking Alpha after a sharp drop in Netflix stock. I summarized that the stock was seeing a bump in the road after lofty valuations and, although the company was not seeing a real crisis, could fall to $300, or even $250 if indices were pressured.

Three days after that article saw hedge fund investor Bill Ackman announce a huge investment in Netflix stock. Ackman bought over 3 million shares for his Pershing Square fund at a cost of around $12bn. He has now been forced to liquidate after the second leg down, which has cost his investors $440 million.

Ackman’s market timing on Netflix was simply poor. The stock was coming back down to earth from an eye-watering valuation, which was accompanied by stuttering growth as I talked about in my January article. The writing was on the wall for Netflix long before its all-time high in November above the $700 level.

Although Ackman dropped the ball, it is an opportunity for investors to learn from a big hedge fund blunder.

What You Can Learn From The Ackman Episode

At the time of the investment Ackman said that, “The opportunity to acquire Netflix at an attractive valuation emerged when investors reacted negatively to the recent quarter’s subscriber growth and management’s short-term guidance.”

The reality is that the valuation was certainly more attractive than the November highs, but that didn’t mean it was the end of the road for the Netflix correction. Ackman showed impatience by taking a huge chunk of stock at a time of market uncertainty. If he had bought 1 million shares, he could now be looking at a very attractive valuation and his fund wouldn’t be reeling from a huge liquidation of the entire position.

I believe Ackman’s mistake was also driven by emotional bias. “We have greatly admired Netflix both as consumers and as investors, but have never previously owned a stake in the company,” he said.

I believe that Ackman’s desire to own Netflix stock overpowered his patience and he moved to take an immediate position that made his fund one of the top 20 investors. This looked great on paper in January but did he do much analysis on the potential downside?

For investors, it is another example of how a value investing approach, removing emotions and bias from the table can win out over the longer-term. Netflix is still a great company but it may be a long time before Pershing Square goes near it again.

Ackman said of the stock dump:

“In response to continued disappointing customer subscriber growth, Netflix announced that it would modify its subscription-only model to be more aggressive in going after non-paying customers, and to incorporate advertising, an approach that management estimates would take “one to two years” to implement. While we believe these business model changes are sensible, it is extremely difficult to predict their impact on the company’s long-term subscriber growth, future revenues, operating margins, and capital intensity.”

What Is The Next Path For Netflix Stock?

At the time of Ackman’s investment, he shared many bullet points on the attractive opportunity presented by Netflix. Here are a few of those:

• its subscription-based, highly recurring revenues, which have enormous future growth potential
• a truly best-in-class management team and unique high-performance culture
• economies of scale and superb quality in its industry-leading content, which should continue to drive future growth and widen the company’s powerful competitive moat

He added in the shareholder letter: “With both UMG and Netflix, we are all-in on streaming as we love the business models, the industry contexts, and the management teams leading these remarkable organizations.

The emotions are running wild again here because the sharp losses on his initial investment have made the investor abandon a sector that he was very bullish on.

Has Netflix lost its ‘highly recurring revenues’? Has it lost its ‘competitive moat’? Has it lost its ‘best in class’ management team?

The answer to all of those questions in no. I believe Netflix is NOW at an attractive valuation and it is up to investors to decide on the growth prospects for the company. The move to a more aggressive pricing policy is being driven by the pressures that were put on the company by Wall Street analysts’ projections. As the dust settles on this latest stock price collapse let us survey the current situation:

A global brand with highly recurring revenues. A world class management team with the experience to continue dominating the sector. A competitive moat that is one of the most impenetrable amongst US tech stocks.

Warren Buffet would be licking his lips and a famous value investor may even step forward to embarrass Ackman further.

Netflix now trades at a price-to-earnings ratio of 21x, which is in the ballpark for a stock market average. The company’s price-to-sales is now 3.47x which is also very modest for a company with highly recurring revenues. The company has a strong return on equity at 35%. Q-on-Q sales were even 16% in the last quarter.

With gross margins of 46% and an operating margin of 20% there is work that can be done by management to slim down the company. The company’s cash flow situation had been improving and this stock market collapse is maybe the shock that management needed to refocus on the balance sheet. The company has maybe hit a wall on subscriber growth but at these valuations it can mature as a company and then start to pursue strategies to return cash to shareholders.

I will end the article with a final excerpt from the Pershing Square letter released this week:

“Based on management’s track record, we would not be surprised to see Netflix continue to be a highly successful company and an excellent investment from its current market value.”

Conclusion

The Bill Ackman investment in Netflix is a great lesson for investors about market timing. Netflix is a great company with a competitive moat, strong management team and recurring revenues. These are some of the key attributes that a value investor looks for. By plunging into Netflix in January, the hedge fund investor ignored the potential downside on the stock which was trying to realign to aggressive Wall Street projections on customer growth and valuation. I warned back in January that Wall Street had misjudged the effects of the pandemic and the writing was on the wall for Netflix stock. Averaging into a value opportunity is often a good strategy and in buying 3 million shares in one tranche at a time of realignment, I believe Bill Ackman has missed out on exposure to a “highly successful company and an excellent investment from its current market value.”