For traders looking to short the stock of digital entertainment subscription service Netflix (NASDAQ:NFLX), the key elements of price and timing are particularly important after the company's shares soared 32 percent during the week following its first-quarter 2013 earnings announcement on April 22. The surge in NFLX from $163 to $215 per share over the course of five trading sessions is enough to make even the most bullish traders consider taking profits, yet this stock seems to confound reason as it continues to build on a whopping 139 percent gain year-to-date for 2013. Determining the ideal price to enter a short position on this puzzling stock requires a brief background on what is driving NFLX performance and the data points that could send its shares into free fall.
Fundamentally, NFLX trades at a stratospheric 516 price-to-earnings multiple with an estimated 36 million subscribers worldwide. The markets have essentially rewarded NFLX with the astounding earnings multiple based on the belief that its digital streaming content business will someday transform the company into a dominant media titan. Netflix claimed in its most recent letter to shareholders that it added 3 million new streaming subscribers in the first-quarter of 2013, which is in contrast to the DVD membership segment of its business that continues to lose members each sequential quarter for the last year. Company executives, as well as many NFLX stockholders, are banking on the growth in streaming content outpacing the diminishing DVD subscription segment that constituted the company's core business until the last several years. In addition to the declining DVD subscription business, NFLX faces rising content acquisition costs that could pose a significant negative impact for earnings in future quarters, according to Wedbush Securities analyst Michael Pachter.
Netflix has two components of its corporate finances that should be alarming to investors and provide comfort for those looking to short the stock. First, NFLX reported negative free cash flow of $42 million for Q1 2013. That represents the third sequential quarterly earnings report with negative free cash flow. In its shareholder letter, NFLX management claims that the primary driver of the continuing negative free cash flow is payments for original and non-original content. This is significant because of the observation by the Wedbush Securities analyst that content costs will eventually damage NFLX earnings. The other important point about the financial position of is that its bonds are rated in the junk category at double-B minus by Standard & Poors. With a junk credit rating, negative free cash flow, and rising content costs, operational challenges abound at Netflix. With the staggering P/E ratio and lofty $215 per share price, the company's fortuitously named original dramatic series "House of Cards" seems an apt description for the Netflix stock price.
From the perspective of technical analysis, the NFLX chart reveals important clues to pinpoint the ideal price to enter a short position in the stock. In July 2011, NFLX reached its all-time high of $304 per share before dropping to a low of $62 per share in December of that year. The stock has climbed out of the trough from a low of $53 in late September 2012 in a parabolic price move that shows some symmetry with the epic nosedive from 2011. The stock is currently positioned at a critical price point for initiating a short position around the $215 level. The area around $245 corresponds to the trading range the company enjoyed prior to NFLX plummeting in September 2011 when it announced that it was losing members after raising subscription rates. While the bad news drove the stock down from the revenue side of the income statement at that time, NFLX may potentially have to disclose similarly negative guidance regarding its impaired profits from higher content costs in the near future.
The company has not meaningfully tested its 20-day exponential moving average since early-December 2012, which is a highly extended period of time without a test of this key indicator. Currently, NFLX is trading 36 percent above its 20-day EMA of around $158, which means the stock is clearly poised for a correction to around that level in the near future. The fact that analyst price targets are wildly divergent supports the underlying case that even investment firms are unsure of the correct valuation for Netflix. Although many analysts upgraded or raised price targets on NFLX after the Q1 earnings report, that actually will provide fuel for short-sellers when those same firms rush to downgrade the stock once negative developments come to light. Consensus among analysts is often a strong contrarian indicator of a stock's prospective performance because of the probability that expectations will exceed actual results.
Ultimately, Netflix is a contemporary company providing a new twist on an old business model. In many ways, the Netflix business model is not much different than the once high-flying - and now bankrupt - movie rental company Blockbuster Video. With low barriers to entry for new competition and large competitors like Amazon (NASDAQ:AMZN) challenging its market share, NFLX is relying on growth models that are unable to forecast the dynamics of such a volatile industry. At its current $215 price and mind-boggling 516 P/E ratio, NFLX stock resembles a late-1990s momentum-driven tech bubble company. For traders seeking to profit from a potential drop in this overvalued stock, the fact that NFLX failed to reach the 2011 trading range level of $245 after its most recent earnings report is a key indicator that investors are not willing to take a risk at that price again. If the NFLX momentum stalls, then initiating a short position at current levels with a primary target around $158 per share is a sound trading strategy with enormous profit potential.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.