“The Matrix is a system, Neo. That system is our enemy. But when you're inside, you look around, what do you see? Businessmen, teachers, lawyers, carpenters. The very minds of the people we are trying to save. But until we do, these people are still a part of that system and that makes them our enemy. You have to understand, most of these people are not ready to be unplugged. And many of them are so inured, so hopelessly dependent on the system, that they will fight to protect it."
- Matrix, 1999
I really am a glutton for punishment. I did everything I could to avoid Netflix (NFLX
) in this earning season. I think there might be some 25 companies reporting this week that I know extremely well and could find some way to trade, but for some strange yet compelling reason I feel it’s time for me to revisit this trade and potentially hit it hard. The last time I traded Netflix it was 140$. It closed on Friday at $182. Did anything happen over that time period that warranted another 50% rise in the stock? Great earnings, a major industry shift in their favor, a brilliant acquisition? NOPE, none of that for good old Netflix. The stock rose on what is commonly referred to as good old fashioned momentum. Up, up, and away became popular, and Netflix, a short favorite, was a good place to be to make fast money.
So, why do I think now is the time to call an end to this momo party?
The way I see it there are five reasons to be short Netflix this earnings announcement.
1) Material Industry Landscape shifting news in the past couple of weeks that doesn’t bode well for Netflix.
) consolidates Lovefilms - Amazon, a minority equity holder, in the "Netflix of Europe," had always been rumored potential acquirer. So, this is not exactly surprising news to most of the people following this space, but it is now official. This means that Netflix will need to contend with an entrenched and very deep pocketed Amazon if it decides to venture into Europe, and I only expect this combination to get better as Amazon leverages its imdb.com asset to enhance the Lovefilms user experience. Expansion to Europe was often listed as the next big catalyst for the stock by most momo traders. This deal becoming official/headline stuff just hammered that thesis.
FCC signs off on Comcast (CMCST)-NBC/Universal Merger- This has been an ongoing and closely watched regulatory situation as the FCC’s conditions to this merger have potential far reaching industry implications. The review process took one year and involved extensive lobbying on both ends. What came out of it was surprise surprise good news for Comcast-NBCU. The "conditions" were for most of us a lot softer than expected, particularly in the on-line video space, were they left a lot of room for Comcast to slow, or depending on how you view things, kill the OVD disruption. (I will say I never really viewed online video streaming as a true disruptive tech because in my eyes the technology infrastructure in the form of vod has been there ... it’s really been more of UI phenomena and media conglomerate lack of strategic direction pricing/loophole exploiter than the genuine disruptor it was to rental chains) Comcast is now sitting on a large equity stake in a competing OVD service (Hulu) and controls a huge content empire. The cord cutting hype that was behind Netflix shares in 2010 is now being replaced by a much harsher reality. The companies best possible outcome now remains what I thought it was before, a very fragmented distribution/content market. The Comcast deal allows more investors to recognize that the Netflix story of getting content for next to nothing and access to distribution infrastructure for next to nothing was in fact TOO GOOD TO BE TRUE. It’s like exploiting a loophole or a glitch in the matrix, it works right up until the point that it doesn’t. What determines that is largely beyond your control. If OVD’s have to deal with likes of Comcast and Time Warner going forward, the cord free universe dream fades away. Dream stocks without a dream attached often lead to disastrous returns.
FCC Net Neutrality- At this juncture I’d say the rules are a Net Neutral for Netflix, though ultimately I am leaning in the direction that they are bad news as the cost of internet streaming relative to traditional bundled consumption is likely to go up which ultimately is an issue for disruptor/switch based model and as we get more details on managed service rules. At the end of the day, OVD’s will have to accept the fact that the only way to get completely around the potential discrimination issues is to build or acquire their own networks. Anyway, as far as nflx shares go, this was another regulatory issue that doesn’t exactly favor their long-term model that was resolved over the past few weeks.
2) If the first week of earnings are an indication, Netflix type stocks are not exactly the place you want to be this earnings season.
Netflix shares are up 257% over 12 months. The stock is currently the best performer in the SP500 over a 1yr period. Those are not under the radar numbers, and going into earnings this could be a serious advantage for short-sellers. Citigroup (C
), Goldman Sachs (GS
), and F5 Networks (FFIV
) were all high expectation stocks that got hammered last week. The latter two on what were respectable reports. A similar but less extreme pattern of stock behavior was observed in the energy, fertilizer, or mineral names that reported last week. Good news was just not good enough for most of these stocks. And remember we are talking about names with fundamental stories that are INTACT and ROCK SOLID. Nobody is questioning the fact that F5 is dominating one of the hottest segments in the networking space or that energy, food, and metals are good places to be. So, if these stocks can get cracked, you need to respect the tape. And what I saw in the tape last week was value/underperforming names drawing interest/ rotation (ms/ge). If I am shorting a momo, I like to see signs of this type of action in the broader market. The fact that this momo has its own issues is icing on the cake.
3) Analyst sentiment on the name now favors the shorts. I don’t usually rely on sell-side analysts for anything more than a temperature check when I am putting on a trade, but I will have to say I have been impressed by the number of analysts who have stuck to their guns and continued to highlight the disconnect between the business model challenges and stock price. The recent industry wide developments have led more than a few analysts to get cautious on NFLX shares which is in sharp contrast to the tape I was shorting into last year. I counted 8 analysts with price targets that are 10%+ below the current share price when I think there were only 2 names in this category last august. This tells me that no matter what NFLX reports, the bearish analysts are likely to be growing even more confident in their case and will continue to spin news flow in favor of their longer term bear case on the shares despite the near term business model momentum. Basically, every NFLX announcement will now be viewed through an Amazon in Europe and Comcast in U.S. competitive prism along with the typical content cost margins issues. If you’ve been buying based on headlines and the fact that you felt momentum was on your side, this is a cause for major concern.
4) This is the perfect time for some shareholder unfriendly corporate action. Netflix’s cash situation has been going in the wrong direction for the past four quarters. With recent developments in the space, one does wonder what Reed Hastings is thinking. He should be shoring up his balance sheet here and raising some cash for the likely expensive content/network access road ahead. It’s the smart thing to do. I think a secondary to the tune of $500-$750mm for general corporate purposes including acquisitions, content licensing deals, etc should not be ruled out. In fact, I’d be pushing for this if I was advising them.
5) First look at a business model in transition. This earnings will be the first time management really has to offer guidance for the transitioning model. Up until now NFLX has had the luxury of cheap content driving streaming while they continued to run their core mail in model. Now, things get a bit more complicated. NFLX is going to be paying big bucks for content in 2011 and at the same time still supporting the mail in DVD model infrastructure. This usually doesn't bode well for margins and might have something to do with the recent DVD que elimination. Management isnt one to do anything to mess with their sub base, so this move really stood out to me as a sign Hastings and Co. want to accelerate the shift to pure digital. Basically, if you are going to spend $500-1bil a year on content you might as well ditch make sure you are completely ditching the mail in model. Management obviously has some accounting room to operate as far as amortizing these costs, but i think it is fair to say it is going to be hard not to give the street a clear picture of what the 2011 NFLX will look like tooday, and that their is potential for a very negative surprise as management has chosen to kick this can down the road over the past few quarters. Well, that is no longer an option. 2011 is here, you still have mail in, you will be paying a lot more for steaming content, and one of your biggest sources of content output is up for negotiation. This is what i am looking at and not the q4 numbers. I think everyone on the street will concede q4 will beat expectations on subs and top line.
Conclusion - Putting these five factors together I have decided to put my hand back in the NFLX fire. I also would point out that stock price action, at least from the perspective of a trader who has seen similar behavior in momentum names in the past, favors the bears. The shares are a good 24% above where they were going into the last report, and less than 12% off its all time closing high. I would characterize the trading pattern as almost just waiting for an excuse to fall. By that I mean I expect the market not to assign much weight to the financial metrics that will be reported after the close on Wednesday. This would be consistent with past NFLX share price behavior as you could convincingly argue their last two earnings reports were disappointing and yet they were disregarded by the market in favor of "story" based buying. Well, with the "story" element now a much harder sell overall, and especially at this price point, you do have to wonder what type of earnings report NFLX needs to prevent a share decline/crash.
Anyway, I would caution anyone that decides to get involved that this is a risky trade, and that my recent history (I was on the other side of the trade in DVD rental days ... but that now seems like ages ago) with nflx has been abysmal. The first time I shorted the shares they were 45% below where they are today, though I will say that my instincts told me the price action in the weeks after the july report said to cover and join the herd on their stampede; I have consistently been surprised by the willingness of investors to pile into the "story" without any regard for what one would think are almost plain vanilla gargantuan business model challenges ahead.
I will note that I expect the stock to shift into consistent weakness mode after this report. So a low risk way to play this trade would be simply to sell calls if you can or to just wait for earnings and then short. Basically, you hope it doesn’t crash immediately, and you hop on for a longer term correction once you confirm that the shares are incapable of rallying. Normally, if I was approaching a story like this as an outsider who was not familiar with the name that is how I would play it, but in this case I will say I have just a bit more confidence that the nonsense of the past six months will be corrected.
Ignore the girl in the red dress, she is a distraction. It’s time to unplug. At least that’s how I am playing this.
Disclosure: I am short NFLX.