Ahead of Netflix Earnings: Use This Options Strategy to Profit

| About: Netflix, Inc. (NFLX)

Netflix (NASDAQ:NFLX) reports earnings after the bell on Wednesday, July 20. Briefing.com's InPlay service provides the key details (click to enlarge image):

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If you don't pay close attention, it might come as a surprise that Netflix guided Q2 down on its Q1 call. The stock price, which recently hit its 52-week high of $277.70, certainly has not suffered. NFLX closed up 2 percent at $267.99 on Friday, despite news that Google (NASDAQ:GOOG) and other online streaming competitors may be lining up to bid for Hulu.

With the call about two weeks away, it makes sense to review several areas of concern, which I think will lead to further earnings pressure. It's telling that the company guided revenue to the upside, but EPS to the downside. This reflects the rising expenses that will come to roost for the company at some point. If Netflix does not miss this quarter, I believe it will report EPS to the low end of its range. I fully expect an earnings miss -- or further significant downside guidance -- over the next several quarters.

The aforementioned rising expenses raise the biggest red flag. Consider the clues CBS (NYSE:CBS) executives flashed on their company's last conference call. When asked about doing business with Netlifx, CBS CEO Leslie Moonves commented:

And in answer to your question about competitors to Netflix, obviously, Amazon is very interested in content, and there are other players who are also having similar discussions to that. So when you look at the Netflix and you say, gee, it's great to be in business with them, and they are terrific, and we feel that way about them, there are going to be competitors who are going to pay the same kind of dollars, and we see that across the way.

What Moonves said supports my contention that Amazon.com (NASDAQ:AMZN) could be gearing up, if it has not already, to deal Netflix a serious blow. Here's what I wrote in a recent Seeking Alpha article:

If Netflix pays to the tune of $300 million per year [for a renewal of its deal with Starz (LSTZA)], it could trim its EPS by $0.40. The time looks ripe for Amazon to open up the war chest to (a) drive up the prices Netflix must pay to acquire content, (b) outbid Netflix on content it wants, and (c) secure key content that Netflix simply cannot afford.

My view meshes not only with what Moonves said, but with the move Netflix competitors appear to be making for Hulu. By lowering EPS expectations amidst increasing revenues, Netlix clearly concedes that it's feeling at least some pressure from having to pony up increasing amounts of money for content.

CBS CFO Joe Ianniello's comments lead me to believe that Netflix will need to guide down or miss on EPS sooner rather than later:

As far as Netflix goes, the way we recognize the revenue is when we make those shows available to Netflix, it is not all in one quarter but it does -- a significant portion does start in Q2. But again, like I said, it's when we choose to make those shows available to them is when we recognize the revenue. So it will be over a period of time. But again, the biggest cost starting in Q2 [emphasis added].

Unfortunately, CBS does not report earnings until early August, so we cannot get more color on the impact of its content deal with Netflix prior to Netflix's report. Because Netflix does not provide specifics as to how and when it accounts for costs from each of its deals, I can only assume that as CBS, for instance, recognizes Netflix revenue, Netflix begins to let it hit the books as an expense. If this is indeed the case (and I have no reason to believe it's not; Netflix cannot defer expenses forever), the trouble could start for Netflix sooner rather than later, given that Q2 is on the books and CBS represents only one of the many content deals with costs about to hit the balance sheet for Netflix.

Investors, for whatever reason, have taken Netflix's word that international expansion is going well. A review of the numbers coupled with Netflix's overly-optimistic outlook shines a very big red flag ahead of the coming Q2 report. Please read the entire article I wrote about the company's international expectations as well as Netflix's Q1 shareholders' letter to make up your own mind. Here's the meat of my argument from the above-linked article:

...Netflix believes that after international losses of between $10 and $14 million, primarily in Canada, in Q2 it will swing to profitability north of the border in Q3? Remember, in Canada Netflix saw net subscriber additions decline and its loss widen between Q4 2010 and Q1 2011...

Things get even more dicey when you consider what Netflix said next in the same shareholder letter:

We’ve also decided to make some early content commitments for a third international market given our high probability of success in our second international market. These third international market commitments won’t materially affect our P&L until next year, and we intend to launch the third international market in early 2012.

Let's try to follow Netflix's rose-colored pronouncements again. Netflix is spending money on its third international market now on the basis of expected success in international market number two, which will lose between $50 and $70 million in Q3 and Q4, 2011. It will follow these losses up with international market number three early in 2012. If we assume similar international losses for market number three in its infancy, it will lose somewhere in the neighborhood of $50 million during two quarters early in 2012.

In summary, Netflix expects us to believe that Canada will swing from a $10 to $14 million loss at the end of Q2 to profitability at the end of Q3. Netflix also tells us that a market that generates a $50 to $70 million loss in the second part of 2011 can fuel expansion into another market in early 2012.

Skepticism aside, let's assume Netflix does turn a profit in Canada in Q3 and breaks even there in Q4. In this optimistic scenario, that makes Netflix's entire $50 to $70 million Q3/Q4 2011 operating loss attributable to expenses connected with expansion into its second international market.

Other than merely presenting the numbers Netflix gives and comparing them to what the company predicts, I am not sure what else I can say. It seems quite clear cut to me. If Netflix pulls this off, it will be equal to Research in Motion (RIMM) having hit their obscene FY2012 guidance. We all know what happened there.

While I anticipate a RIMM-like implosion coming for Netflix, I acknowledge that the street loves this stock. Theoretically, it should have taken a hit after Netflix guided down EPS for Q2 and it should have taken a hit -- one that stuck -- after the Hulu news broke last week. But, this stock gets love and rides momentum like no other.

Given this reality, a relatively conservative options play, not an outright short, makes sense ahead of Q2 earnings. For instance, consider a bear put spread. This scenario provides a hedge because you offset part of the cost of buying a NFLX put by selling a NFLX put in the same month, but with a lower strike price.

For instance, prior to the Q2 report, you could buy the NFLX August $250 put for roughly $9.35 and sell the NFLX August $220 put for about $3.05. Excluding commissions, you could put this spread on for $630 per combination. You limit your loss to that amount.

If you believe Netflix could falter near-term, but not collapse for several more quarters, consider the use of a bear put calendar spread. This involves selling a near-term put, but buying one, at the same strike, with a later expiration. For instance, you could write an August put and buy a January 2013 LEAPS put option.

If NFLX falters after July earnings, but holds above the strike you select, you keep the premium from the August put you wrote. Assuming a steady decline going forward, the LEAPS option could start to turn profitable. If the Q2 call does not offer up more pessimism, inline with my analysis, don't stay in the trade. Take a small loss and live to fight another day.

I put my performance -- good and bad -- out there for the Seeking Alpha audience to see. I've made some bad calls, no doubt, but I nailed RIMM. And I firmly believe NFLX will go down like RIMM. While it might not happen hard and fast on the July call, I think the downward trend finally starts with that report.

What RIMM claimed it would do EPS-wise for FY 2012 could not have been more out of the realm of any sane person's conception of possibility. Netflix's earnings outlook -- particularly when you factor in the international story -- is not far behind on the spectrum RIMM set for the likelihood of earning's failures.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.