The Glass Is Finally Half-Empty: Sell NFLX in Front of Earnings

Jan.22.11 | About: Netflix, Inc. (NFLX)

After watching the reactions to strong earnings reports from companies like Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), F5 Networks (NASDAQ:FFIV), and Schlumberger (NYSE:SLB) (among others), it appears that investors' glasses are finally half-empty after a multi-month run up for the stock market. Investors seemingly spent most of the fourth quarter buying the rumor, and are so far in January selling the news. In particular, the clobbering that FFIV took on the heels of their guidance makes it particularly clear that stocks raced ahead of fundamentals, and at this juncture there is no room for companies with lofty valuation multiples to report anything but blowout numbers and guidance.

In light of this change of heart by the market, I have been looking for other stocks than could be setting up for similar declines. Netflix (NASDAQ:NFLX) stock certainly screens well as being at increased risk of a selloff after its earnings report on January 26th, even if if is fairly upbeat. Like FFIV, NFLX is a stock that spec longs have somewhat blindly chased because it has worked, while shorts have lost their shirts over the past 18 months. Regardless of their direction, very smart investors have scratched their heads the whole way up, unable to understand its valuation or the longer-term competitive business model. But for the time being, the fundamental results have been hard to deny.

Interestingly, short interest on NFLX has actually fallen by about two million shares just since September 2010 - an indication of some recent capitulation by the shorts. Undoubtedly, there is some scar tissue for these NFLX shorts. There would be more than just a few investors who would gladly jump back on the NLFX short bandwagon (even for a day or two) at the first sign of blood here, if for no better reason than to salvage some ego.

The stock has been quietly treading water over the last couple of months, with daily volume being highest on down days recently. The stock is now sitting on its 50-day moving average which admittedly has been a solid support for the stock over time (the exception being August 2010, when the stock broke below the 50-day - also on big volume). A similar break to the downside from current levels could take the stock to at least its 150-day moving average, which would be about $152/share. At that level, NFLX would still be trading at 39x forward consensus EPS estimates, which would be a little more reasonably aligned with the expected consensus growth rate for revenues and earnings over the next year (but still not "cheap" by any means). This would also represent about 20% downside in the stock from current levels.

But beyond sentiment and some questionable near-term technical indicators for the stock, there are some fundamental issues that have been hashed out ad nauseum in the public domain that could be catalysts for the stock to sell off.

For example, NFLX is pushing its relatively new streaming-only plan and is rolling out increased rates on mail plans this month. While the rationale for pushing toward a streaming model may make sense longer-term, the likelihood of a hiccup in the near-term outlook for subscriber growth and/or sequential revenue growth substantially increases as NFLX fundamentally changes its business model and tries to migrate its customer base's way of using its service. Beyond the top line, there's also a higher probability that margins will compress (i.e., costs rise) near-term as the company makes this transition.

From a competitive standpoint, the competition for streaming content -- namely Apple, Amazon (NASDAQ:AMZN), Cable companies, etc. -- are much better capitalized and formidable than those NFLX faced as it rose up to become the dominant player in traditional DVD rentals -- think Blockbuster Video (BBI). This is a longer-term reason to short the stock though, and likely won't have much impact on nearer-term results.

Then there's the conspiracy theory - NFLX's CFO resigned during this past quarter. While this does not necessarily forbode a problem, my experience is that any time there is some transition at the CFO position there is a meaningful increase in the risk of a slight operational misstep, or some (even small) reset in forward guidance to make the hurdle easier for the new guy. But there's always that less likely but possible probability of a deeper problem that reveals itself in following quarters.

For these reasons, I think the time has finally come to view the glass as half empty on NFLX, and view the stock as a higher-probability short in front of its earnings report on January 26th. But lest I become just another remnant in a long line of road kill trying to pick the spot to short this stock, I suggest buying put options on NFLX to limit your downside risk. For full disclosure, I am long the NFLX March 175 put contract.

Disclosure: I am short NFLX.