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Like most portfolio managers or analysts I have been a lukewarm fan of Netflix's (NASDAQ:NFLX) streaming product for the past few years, while being a huge bear on the stock. Actually I should clarify, I was a bear when it first broke $200 back in early 2011, stopped caring when it broke through $100 on the downside that same year, and started paying attention again after its Q4 release of last year (which took place early this year). Since that time I've been trading options on the stock around earnings, with some minor success.

In Q1 I bought both a put and call spread and the call spread paid off. In Q2 I bought just the put spread, and while it didn't pay off in full I was able to liquidate the position at a small loss. Both times I modeled what I thought the company's earnings would be for the quarter, given the known quantities (which change every quarter, since it releases information randomly) and both times my estimates were good for subscribers, but proved wildly optimistic on total earnings. Generally this is because while revenue is relatively easy to predict, the cost of those revenues (read: increase in streaming content costs and obligations) is much more difficult to predict. For the record my estimate for this quarter is $0.60 versus street estimates of $0.49.

With a valuation currently hovering around $20 billion USD, my view is that NFLX eventually needs to get its annualized profit on streaming to around $2 billion dollars. This would leave it with around $1 billion of after-tax profit after paying fixed costs and a P/E of 20x earnings. With my current assumptions on costs that would mean a total subscriber base of 53mm paying customers (assuming zero churn and that they pay the full $96/year for Netflix's streaming services and no increases in any expenses). That really isn't a far cry from their current 35.6mm paying customers (as of Q2 end, we'll see where they are after tonight's release) and it is entirely possible that they could get to 53mm customers within the next few years.

The $64,000 question is of course: how possible is it? The reason each earnings release is so important for investors (and why the stock moves so much) is because there are several barometers for success embedded in the report. If the company is able to meet or exceed expectations on all three of these things, the stock will probably go up. If it doesn't meet expectations then I would expect some investors will call the lofty valuation into question and the stock will drop. So here's what I'm looking for in this earnings release:

1. Streaming Content Obligations (also known as SCO)

This is by far the most important thing on the cost side for NFLX. Every quarter they publish their current (less than one year) and future (one year and longer) streaming content obligations. Since Q4 2011 total SCO has increased from $4.8 billion to $6.4 billion, an approximate increase of 33%. While the increase is hefty, it is far less than the increase in streaming revenue over the same period (65%). However, in Q2 the increase in obligations (12.26%) was actually larger than the increase in streaming revenue (7.21%). While I suspect that increases in these obligations are more likely to occur in Q2 and Q4 (theoretically when blockbusters are released and their rights negotiated, but I'm not a Hollywood expert), I would not like to see growth in these obligations continue to outpace revenue. With expected streaming revenue growth of just 4-5% (QoQ, based on 1mm net adds) even a small growth in streaming content obligations could be worrisome.

2. Domestic Subscribers

This is obvious. Since December 2011 NFLX has increased domestic subs by just over 40%. While this is impressive, there is some concern that 30mm subscribers may be the practical limit to their US subscriber base. I could see why the June and September quarters might be slower for subscriber growth, with nicer weather and baseball season, but I would expect that NFLX only has a couple quarters of low single digit domestic sub growth before investors get nervous. Street estimates are for just 1 to 2% domestic subscriber growth this quarter (QoQ).

3. What you think Carl Icahn will do

This isn't really a fundamental thing you can see on a piece of paper, really this bullet point should be international subscribers if we're just looking at fundamentals, but it is illustrative of a point. Carl Icahn famously bought almost 10% of NFLX when it was trading under $100 on the advice of his son. He wanted to sell when the stock got near $200, but relented when his son threatened to quit if he did. So with his $320 million investment now worth a staggering $1.9 billion (at $345/share), it might make some sense for him to take some money off the table.

The problem with NFLX, in my opinion, is that it is a momentum stock. One that has gained momentum because it has a compelling growth story behind it, but as everyone points out a lot has to go right in order for NFLX to earn its current valuation. None of that is a problem while it is going up though, investors are making money and are happy to hold it (and who wouldn't be with a 275% YTD return and 434% 1 year return), so long as they are making money. Once that momentum ends and investors get concerned about previously unthinkable things (like the stock going down), NFLX does not currently have a fundamental valuation it can fall back on. So if Carl Icahn sees something in this quarter (or any future quarter) that he doesn't like, the 'momentum valuation' will probably come to an end.

A high valuation, a 9% holder who wanted to sell "over 100 points ago", and slowing domestic subscriber growth puts NFLX in a precarious position where it needs to hit it out of the park with virtually every single quarter. In my opinion this skews the risk/reward of each earnings towards the downside, as meeting expectations (or slightly beating them) may no longer be enough to propel the stock higher. As such I will be shorting (through options) the stock into the close.

How I will be shorting

I'm already long a put spread with 2015 expiry, so I have some exposure. However, it's hard to resist the allure of the weekly expiry options. The long term expiry is more of my fundamental call (that the stock will falter sometime in the next 6 or so quarterly releases), and any short term calls are more of a gamble. As such, the positions need to be sized accordingly, so I wouldn't recommend betting the farm on this quarter. When doing earnings plays I generally look to make a small bet that could triple or quadruple in value, which is why short term spreads are generally a good option. Because of the extreme volatility around NFLX earnings (22% average move indicates an 'expected' price range of $273 to $422, assuming the price is $350ish) spreads tend to be relatively expensive. In this case I really don't expect the stock to move violently to the upside and $400 would really be pushing it on the upside, as $300 would be on the downside.

Since I want to be a downside player I then look at what my "best case" downside would be, which is probably $300. A $305-$300 put spread (long the $305, short the $300) would cost me $1.25 (4:1 payout) and is the most optimistic (or pessimistic depending on your point of view) scenario I'm willing to bet on. A $340-$315 put spread, however, is much more conservative and would cost me $10.00 (2.5:1 payout ratio). My breakeven on the $340-$315 is $330 and my breakeven on the $305-300 is $303.75. Really because of the massive difference in break-evens, but the relatively small difference in payouts, it makes a lot more sense to go for the $340-$315 spread. If I thought that wasn't aggressive enough I'd still be better off doing primarily that spread and then picking up a $290-$280 (or something in that neighbourhood) for $1.25 and an 8:1 payout ratio.

Disclosure: I am short NFLX. 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.

Additional disclosure: Short through options.

Source: Three Things To Look For In Netflix's Earnings Tonight