How to Play Netflix Through Earnings

Jan.25.11 | About: Netflix, Inc. (NFLX)

A plethora of high PE stocks have been taking hits lately. The F5 Networks (NASDAQ:FFIV) miss, which resulted in an approximately $25 price drop, seems to have started a trend. (NYSE:CRM), Riverbed Technology (NASDAQ:RVBD), Netflix (NASDAQ:NFLX), VMware (NYSE:VMW), OpenTable (NASDAQ:OPEN), etc. have all fallen since the report. On Monday, VMW beat expectations and still fell after hours by more than $4. This seems to confirm the high PE stock downtrend, especially after earnings. These stocks are “priced for perfection.” Anything less seems to cause a sell off at this moment in time.

NFLX reports on Jan. 26, after the market closes. It has a PE of 70 and an FPE of 48. The current price is $183.96, but the current average analysts’ target price is $155.04. This data alone indicates that there is a strong risk of downside movement on earnings. If you add the fact that NFLX earnings were lower in Q3 ($0.70/share) than in Q2 ($0.80/share), one is more convinced a down movement on earnings is likely. High growth stocks need to show high growth in earnings. NFLX added approximately 2M subscribers during the Q3, which should have meant more profits -- but didn’t. It has been spending ever larger amounts of money on content.

There are many people who think NFLX is a good short -- myself among them. Whitney Tilson’s article is the most thorough one I have seen on the subject. It can provide you with further information about NFLX’s fundamentals. Even if you scoff at these, it would seem obvious that the momentum trade on these stocks (cloud and Internet service stocks) is broken for the moment. From a fundamental standpoint, they are far over valued. The break in the momentum may well see them fall to much more reasonable levels. NFLX has a book value per share (MRQ) of $3.67/share This is so far from its price of $183.96 as to be ludicrous. Even if you multiplied this value by 20, that value would be far below today’s price. It is far over-priced. Even Apple (NASDAQ:AAPL), which doesn’t have a particularly high PE, has taken a hit recently. Momentum stocks are taking a holiday.

Still, NFLX is heavily shorted (31.50% of the float as of Dec. 31, 2010, per Yahoo Finance). The trader has to be very wary. On a big beat, NFLX might get short squeezed even against this current high PE stock downtrend. What do you do?

If you own NFLX, you could sell it before earnings (or you could protect it with puts). If you think you want to bet it to the downside, you could short it ... or you could buy puts, which are much cheaper. The problem is that NFLX puts are still very expensive.

The play I like is to buy an out-of-the-money put spread. You could buy a $170/$165 Jan. 28 bear put spread for $1.25. If the stock falls below $165 (and you are expecting a large move if you are doing this), your put spread will likely move in value to $4.75 or so by the end of this week (Jan. 28 expiration). This is a tripling of your money in just a few days. If you are wrong, you are only out the cost of the put spread ($1.25). If you bought a $170 put option, it would cost you $3.85, and you might lose all of that if the stock failed to fall for any reason. Of course, you could profit a lot more if NFLX fell more dramatically. I selected the Jan. 28 expiration date because I am only trying to capture the earnings event. I can always buy more options that are later dated if I choose to.

If you are convinced NFLX will go up, you can do the same in reverse with a bull call spread or a bull put spread. Using this method, you can capture a good profit, with much less risk. Keeping risks low is a good thing.

The FFIV three-month chart below shows FFIV’s reaction to its earnings:

[Click all to enlarge]

Click to enlarge

The NFLX three-month chart below shows NFLX’s stalled and perhaps turning momentum:

Click to enlarge 

If you are making a short bet on earnings on NFLX, you will be encouraged to know that the U.K.'s GDP number came in at -0.50% on Tuesday. This was a big miss from the expected +0.50%. This will likely encourage stocks to go down in the near term.

Good luck trading.

Disclosure: I am short NFLX.