Fade The Netflix Short Squeeze Pop On Q3 Earnings

| About: Netflix, Inc. (NFLX)


NFLX pays no annual dividend.

NFLX's PE of 371.47 and FPE of 136.64 are unjustified by fiscal fundamentals and by likely growth.

Huge companies such as Alphabet and Amazon.com (as well as major studios and others) are quickly becoming more formidable competition for Netflix.

Hopefully this article will help you grow your assets.

Netflix (NASDAQ:NFLX) is a multi-national internet television and movie network. It delivers TV shows and movies to computers, tablets, phones, and other devices within the US and internationally. It produces TV and movie content. It has two main segments: domestic streaming and international streaming.

NFLX has been a momentum darling for many years as rapid subscriber growth has kept it in Wall Street's spotlight. The Q3 2016 earnings report seems to have stoked that momentum once again. NFLX's revenues were up 32.2% year over year. They beat by +$20 million at $2.3B. EPS were +$0.12/share. This beat the estimate of $0.05/share by a huge +$0.07/share. The total streaming net subscriber adds for Q3 2016 rebounded to 3.57 million from the miserable 1.68 million in Q2 2016. The Q3 2016 net adds were only slightly below the 3.62 million of Q3 2015. Plus NFLX's forecast for Q4 2016 was far higher at 5.20 million. Still this was down from the 5.59 net adds in Q4 2015. In other words the "death knell of Netflix", which many thought the Q2 2016 net adds foretold, does not appear to be coming about as quickly as some had concluded after the Q2 2016 earnings report. The roughly 19% jump in the stock price on the earnings announcement reflects the improved psychology of the stock. Momentum traders are buying on that.

However, the short interest on Netflix is far down from its December 31, 2015 level of 13.47% of its float at its current 8.05% of its float. This is likely enough to support the short squeeze on a positive earnings surprise that we are seeing; but it is unlikely to be enough to sustain a long term NFLX rise.

Consider that US subscribers are the main profitable area for NFLX currently. NFLX's Net Adds for the US market were only +0.37 million in Q3 2016 compared to +0.88 million in Q3 2015. US Net Adds appear to be slowing. When you remember Reed Hastings cited the Law of Large Numbers earlier this year with regard to future US Streaming growth, you have to think that US streaming growth may be slowing to a stop (or even reversing) over time. Reed's reference to the Law of Large Numbers may have been a misuse of that law. However, his point that NFLX is much closer to saturation of the US market was very apt. His point about increased churn in the US market was apt. This is even more true when you consider the increasing competition from the likes of Amazon (NASDAQ:AMZN), Alphabet (GOOG), Apple (NASDAQ:AAPL), HULU (owned by a consortium of entertainment companies), and others.

When you look at NFLX's PE of 371.47 and the FPE of 136.64, you have to consider that NFLX may be overvalued. The PEG ratio (5 year expected) is 6.40, which is far above the norm for a quickly growing stock. For instance, Facebook (NASDAQ:FB) has a PEG ratio of just 0.92. Alphabet (NASDAQ:GOOG) has a PEG ratio of just 1.26. Even perpetually overvalued Salesforce.com (NYSE:CRM) has a PEG ratio of only 2.41.

NFLX is not a "NEW" stock. It has been around; and its bread and butter growth (the profitable US market) has been drying up. In the US market the churn is coming close to equaling the Net Subscriber Additions. That is not a positive for a company that just popped about 19% on earnings to an extremely high PE of 371.47.

Remember also that NFLX EPS have not gone straight upward. For instance, the Q4 2014 EPS were $0.19 per share. Q4 2015 EPS were only $0.10 per share. Don't forget that NFLX recently decided to abandon its great growth hope, China, for now. It decided to only license its content for use by other media providers in China instead of building its own system. That was probably a wise decision (for now). However, it still means all of the revenues that the NFLX stock lovers were foreseeing from China will not be forthcoming anytime soon. However, NFLX's strategy does allow for added revenues from "in-house" produced content licensed to Chinese media providers.

After Q1 2016, AMZN Prime US memberships were estimated at 54 million. In contrast NFLX US memberships were 47.13 million (46.00 million paid memberships). AMZN is already technically the largest video streamer in the US, even though it has been in that business for many fewer years than NFLX. There is no doubt that AMZN is growing faster. One item that detracts from the above AMZN number is that in a survey 20% of Prime members said that they had never used Prime's video streaming. However, 8% of Prime members apparently didn't know their Prime membership gave them free access to AMZN's video streaming catalog. It sounds like many of that 8% would have been using Prime's video streaming features if they had known they were getting them for free.

Some might say that Amazon is unfairly winning the video streaming subscriber net add battle in the US because a lot of people actually want free shipping. However, AMZN is also offering an $8.99/month video streaming only service to customers. This is cheaper than NFLX's standard streaming service for long time subscribers at $9.99/month. In addition Amazon is producing a lot of proprietary content "in-house" in much the same was as NFLX. The content from AMZN won 5 Emmy's in 2015 compared to content from NFLX's 4 Emmy's. That's pretty good for the new guy on the block. Notably HBO won 43 Emmy's; and NBC won 12 Emmy's. In 2016 the picture reversed itself. NFLX's content won 9 Emmy's; and AMZN's content won 6 Emmy's. Overall NFLX seems to still be the leader in this area; but AMZN is no poor cousin in artistic talent or in money. AMZN also has access to some of HBO's older content, which is generally considered great. Plus it has access to popular movie content such as the Bond movies, the Lethal Weapon series, etc.

If one judges by Emmy wins alone then HBO would have to be the streaming service you chose. It used to be that you had to have Cable in order to access the HBO service; but these days HBO offers its content over the internet. This content is available all of the time. A subscription costs only $15/month. In early 2016, this service ("HBO NOW") had only about paying 800,000 subscribers though. HBO still does the vast majority of its business on Cable. On Cable HBO and CINEMAX combined have about 50 million paid subscribers domestically and another 81 million paid subscribers internationally. This is more than NFLX's US streaming 46.48 million paid subscribers and NFLX's international paid subscribers of 36.80 million.

Hulu is effectively an on demand platform for the major networks. It offers its content at $8/month with commercials or at $12/month commercial free. If you enjoy the major network shows, you may enjoy Hulu. In April 2015 Hulu claimed just 9 million paid subscribers.

Alphabet is competition too. Youtube has about 1 billion subscribers, who are willing to have commercials. YouTubeRed is a commercial free subscription service for YouTube. The company estimates that 3% (4.5% by 2022) of the 1 billion YouTube subscribers will buy YouTubeRed subscriptions at $10/month. That 3% amounts to 30 million paid subscribers. Yes, it is enough to eat into NFLX's subscriber count. Yes, YouTube has even bigger availability internationally than NFLX. That extra availability may prove to be important.

There is more competition that which I have named. Plus many of the competitors named above are expected to grow dramatically. They represent large competition for NFLX. They represent extra cost for NFLX in higher churn rates too. NFLX will have to do a lot more than just follow the golden brick road. It will be seriously tested in the months and years to come; and it already seems clear that growth in its US market is abating. Growth in NFLX's US market may even be close to reversing itself. To prevent this NFLX will have to spend even more; and that will cut into profits. NFLX was the first big service; but its competition is hard on its heels, if not ahead of it in the US in AMZN's case. Further AMZN and GOOG already have big international presences. They may be able to compete in many international markets much more effectively than NFLX. Cramer may be lauding Reed Hastings. Reed Hastings may even be doing a good to great job. However, the reality is that NFLX is finally in direct competition with big internet players in AMZN and GOOG; and it is in competition with the big entertainment players with the owners of HULU and HBO.

Logic says these big players could squash NFLX like a bug. At the very least they should provide increasing competition for NFLX. Plus the US market is already close to saturation for paid video streaming. US citizens simply cannot afford to watch TV all day (unless you are retired). Those analysts who are predicting an unlimited future for NFLX are mis-reading the tea leaves. It has only begun to feel the pain of the substantial competition. It has only begun to pay the likely very dear price for maintaining a leading position in the increasingly growing and crowded field of paid video streaming.

Those who remember when NFLX started switching to "in-house" content will remember that the reason for that was the exploding costs for content. I was one of those people. I remember thinking that it would only be a matter of time before the costs of "in-house" content exploded. That process may have just started; but it will likely soon get as ugly as the studio content price wars became. NFLX has likely only delayed onset of the increased content costs.

To its credit NFLX has become a good small entertainment studio itself. However, there is increasing competition in this space too. Nothing about this situation will be as glamorous or as easy as Jim Cramer has been touting. Fade the rally. The PE (371.47) and FPE (136.64) numbers for NFLX are far too high for it to be a good investment in this environment. The competition has too many advantages. One of them is far superior size in many cases. Another is a lot more experience in the entertainment business in other cases. NFLX's Q3 performance was heartening; but the apparent profit improvement is destined to be short lived. Further let's not forget all of the localization costs associated with foreign streaming. Lets not forget that tastes are different in many countries. One size does not fit all. That too will prove to be an added cost. Let's not forget that CFO David Wells announced NFLX would be taking on significant debt to fund some of its future content costs. That debt will become a significant cost in itself; and that too will cut into profits.

The five year chart of NFLX provides some technical direction for a trade/investment.

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Technically the chart of NFLX looks tired. It may have popped on earnings. However, I believe I have presented good fundamental evidence that the pop is not likely a signal that NFLX is going to suddenly grow rapidly. Readers should also remember the conference call warning that Q1 2017 may be a tough comparison quarter. NFLX says it got a big pop in international subscribers on pent up demand in Q1 2016, when it started streaming in many international countries at one time. Further remember that the PE (371.57) and FPE (136.64) are astronomical. Peter Lynch used to tell investors to avoid such "nose bleed" stocks. When the fundamentals for even good subscriber growth look questionable, this advice is doubly true. Technically the chart above makes one think that the next direction is down. There is some support at approximately $90/share. There is more support at about $68/share. NFLX is capable of falling to either of these levels relatively quickly. It is a SELL. Some analysts might more politically correctly tell you to fade the pop on earnings.

Further consider that the EU economy is in trouble. Remember the biggest bank, Deutsche Bank (NYSE:DB), is in trouble. Greek problems will soon be revisited. The Italian Referendum scheduled for December 4, 2016 may cause a lot of turmoil if Renzi's proposal does not win. He has pledged to resign on a loss. In that case the Five Star Party is likely to take over; and the Five Star Party is said to favor Italy leaving the EU. Theresa May, the UK Prime Minister, says that the UK will trigger article 50 of the Lisbon Treaty (for the UK to start the two year withdrawal process from the EU) by the end of March 2017. Scotland says it doesn't want to leave the EU; and it may have another secession referendum from the UK soon. Many think the UK is in for a recession in 2017.

China is seeing a slowing economy that may trigger severe credit problems soon. Bad troubles in the EU and/or in the US are only likely to increase the credit and slowing growth problems for China. On top of that more economists and strategists seem to think that the US economy may be in for a recession in 2017. The above items could all feed on each other to make the situation in each case worse. I could go on; but the real point is that the world economic outlook for 2017 is not a good one at this time. Growth stocks are often the ones that get clobbered the worst in bad economic times. Fade the NFLX earnings pop (SELL).

NOTE: Some of the fundamental data above is from Yahoo Finance.

Good Luck Trading/Investing.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in NFLX over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.