Netflix: High Flier or Falling Star?

Tuesday marks the unofficial beginning to earnings season. When Alcoa Inc. (AA) issues its first quarter report after the close, it will touch off one of the most important quarterly earnings periods that the market has seen in years. Why is this quarter so important? Well essentially, investors will be looking for fundamental proof to help back up the latest rise in stock prices.

As traders, it is important to know which companies are the most likely to bring surprises which move stock prices. Surprises can come in the form of different earnings numbers, but more often come as a result of management issuing different guidance than previously expected. And this brings up a difficult question: What exactly are investors expecting from each stock?

Netflix Inc. (NFLX) offers us a prime example of a stock whose investors are expecting great things. Since its October low of $17.90, NFLX has climbed 151% hitting an intraday high of $44.90. That’s astounding in any market, but especially impressive considering how difficult the last two quarters have been.

The strength of the stock stems from the success Netflix has had in signing up new customers. Many consumers have used video rentals as an inexpensive alternative to more pricey entertainment. In the fourth quarter alone, Netflix added a net 718,000 subscribers. And since the company’s costs are relatively fixed, much of the revenue from these additional subscribers flowed directly to the bottom line.

The Short Case for Netflix

It may surprise you that with so much strength in a difficult economy, I am actually suggesting a short position on this stock. But as we gear up for the earnings report later this month, I expect any surprises to be on the negative side. When you have a stock trading at such a high price as Netflix, any disappointment can lead to very large drops in the stock price.

To understand the bear case, let’s first look at what bullish analysts are expecting:

• Subscribers: While management issued guidance for 10.1 to 10.3 million subscribers at the end of Q1, Barclays is generously placing expectations at 10.324 million.
• Revenue: Guidance from the last conference call pointed to $387 to $393 million in revenue. Barclays advises clients to expect the high number at $393 million.
• Earnings: Finally Netflix told investors to expect $0.25 to 0.33 for earnings in the first quarter. Barclays has published expectations at $0.32 which is certainly at the high end of the range and may or may not be optimistic.

Now whether these numbers get hit is really just academic. The point is that investors have extremely high expectations for both the first quarter and for the entire year. That is why you see the stock trading at 30 times the reported earnings. It would seem that even if the company reiterates the current guidance, the stock would still fall because investors are disappointed that guidance was not raised.

Looking further down the horizon, there are a few situations that could arise and challenge Netflix:

• Profit Margins: At this point the company enjoys relatively low costs for the video content. But if studios begin to push the cost of content up, it could quickly cut into the profitability measures.
• Competitors: Currently there are a few smaller players that offer similar video rental or online streaming solutions. But the cost of entry into this market is very low and a new competitor could arguably begin to cut into NFLX’s market share and steal customers away.
• Cost of Customers: Right now it costs roughly $26.67 per gross additional subscriber. Now gross additions are very different from net additions. As customers cancel subscriptions, the net number (718,000 last quarter) can be very different from gross (2,085,000 last quarter). So these costs to add subscribers could become a drain on earnings.
• Exclusive Agreements: Netflix continues to seek agreements for distributing their media through specific devices. So far the Roku and TiVo (TIVO) platforms have agreements through Amazon.com (AMZN)’s digital offering, and more deals could pressure Netflix.

Barclays is expecting the next three years to bring 15 to 20% annualized growth which makes a 30 multiple a bit hard to rationalize. So at this point I believe there is enough risk in NFLX to short the stock, or potentially to buy puts. As always, traders should use discipline and have an exit strategy if the stock moves against them. Use caution, but don’t be surprised to see this stock lower in the coming months.

NFLX Notes

Disclosure: Author does not have a position in NFLX.

Comments

[Wall_St_Geek:]

<<And since the company’s costs are relatively fixed, much of the revenue from these additional subscribers flowed directly to the bottom line.>>

Not sure how you arrived at this conclusion. Each new sub is not more profitable than prior subs. Their SAC cost is fixed - per - sub, but therefore is variable, and their content licensing and fulfillment costs are also variable based on the number of movies watched. While their G&A expenses are largely fixed, this represents a smaller portion of their overall expense base.

Apr 08 09:19 AM

[jkk:]

I am suspect of its recession proof status - Netflix subs were falling significantly into October 2008 and bounced big after the Xbox streaming was enabled - as many people signed up to try this service - thus lowering SAC significantly - the streaming hype has appeared to fade per Alexa.com reach charts for Netflix -

Apr 08 10:35 AM

[JamesD:]

You're ignoring the fact that most of investors' high expectations ride on Blockbuster going bust. Whether BBI holds up or folds up is far and away the biggest driver of Netflix's pps.

BTW, if content price can whipsaw NFLX profits, how on earth can you say in the next breath that the cost of entry is low? (Ask Redbox how cheap it is to get up and running!) The only serious competition for NFLX is going to be Apple's iTunes store, and Apple's software wizardry and mountains of cash makes them a formidable foe. (They could buy NFLX in a minute, out of petty cash.) I'll get nervous about NFLX share price only when that battle starts heating up. Even then, Apple seems not to be predatory -- unlike MSFT, they just roll out incredible products and let you compete, if you can -- so NFLX has a fighting chance.

Apr 08 04:48 PM

[Zachary Sch...:]

Streaming is certainly much more profitable than the more "traditional" online queue with actual DVD's that get mailed. Ironically, the user experience is actually better (provided the customer has a high quality way to download and view these videos).

I actually don't think a BBI bankruptcy would be as big as you imply. A content company (heck even the producers) could get into the business without startup costs putting them out of business. Sure there is some investment but if the business is set up right, it can be done.

My argument is not that NFLX will go out of business - or even that the company will weaken. But more that the stock price reflects optimism that is exceptionally high. It will be very difficult for NFLX to top the current runaway expectations - and this will likely lead to a drop in the stock.

Thanks for the comments guys!
Zach
zachstocks.com

Apr 09 10:02 AM