Will the Netflix Drama Have a Happy Ending?

Aug.18.11 | About: Netflix, Inc. (NFLX)

Stocks can often provide more drama than action movies.

Netflix Inc. (NASDAQ:NFLX), an online movie rental subscription service, is no different. Having reached a record high of $304.79 in July, Netflix stock closed at $232.24 on Wednesday, Aug. 17, 2011. Netflix has a current market capitalization of about $12.2 billion, and a P/E ratio of about 59, after having reached at its height a market capitalization in excess of $16 billion and a P/E ratio of over 78.

Traders and investors justified such hefty valuations by pointing to the company's impressive annual sales growth estimated at over 52% for 2011. However, following the adoption of a new pricing strategy, Netflix reported earnings of $1.26 for the quarter ending June 2011, beating analyst estimates of $1.11, but missed revenue forecasts. In addition, Netflix announced expected revenues for Q3 2011 at about $805 million, substantially below analysts' forecast of $845 million.

Although current stock valuations for Netflix continue to be hefty, despite the recent stock price pullback, some are maintaining faith following the company's announcement that it expects revenues to top $1 billion in Q4 2011.

The movie script is set. The climax is now tied to Q4 2011. Either Netflix will restore faith in its business model by meeting its own revenue forecast, or it will fall flat on its face for failing to deliver on its promise. With hefty valuations, it is risky to buy the stock outright given recent volatility in the broader market, as well as volatility in the company's own revenue forecast. At the same time, it is also risky to short the stock given that Netflix boasts one of the highest short interests in the market at about 20%.

Either way, it is reasonable to expect Netflix share price to make a substantial move in either direction pending its revenue performance for Q4 2011. Although options are quite pricy at these levels, it may be justified to establish a direction-neutral position by buying March 2012 puts with a strike of 180, as well as calls with a strike of 285. However, with the current combined premium at about $30, it may be best to refrain from executing such trade at this time, but to place such trade on one's radar, awaiting a drop in implied volatility levels (in case VIX index drops back to the low 20s).

In the meantime, continue enjoying the flick.

Disclosure: Author has no positions in Netflix.