Netflix Earnings Preview: Big Trouble Ahead?

 |  About: Netflix, Inc. (NFLX)
by: Gutone

Netflix (NASDAQ:NFLX), the falling angel from a high of over $300 to a low of $65 in 2011, has already gone through one round of roller coaster ride. As I wrote in a previous article, Netflix is a typical pump-and-dump situation as investors get excited over unrealistic growth prospects and ignore the fundamentals of valuation.

After hitting a low of $65, Netflix has bounced back nicely to almost $130. It is current at slightly above $100. Most people in the market perhaps wouldn't imagine Netflix still has more glorious days ahead. But its current price of $100 seems to be within a reasonable valuation range.

Or is it?

In the light of Netflix's earnings report today, I expect the company to issue pessimistic guidance and we should see a sizable drop tomorrow. Here's why.

Netflix is a subscription based service. Its value is very straightforward to calculate based on the number of subscribers. Currently, it has about 12 million DVD subscribers and 20 million online subscribers - that's approximately $3.5 billion a year in revenue. At a 10% profit margin, and a price/earnings (P/E) multiple of 10-15, it's worth $3.5-$5 billion. If Netflix can maintain its subscriber base and margin, it's worth between $65~95.

The key in projecting Netflix's future earnings lies in forecasting the number of subscribers. Based on the following chart of Google search volume, comparing to the same period of 2011, I can calculate that Netflix had virtually no subscription growth during Q1 2011.

But there is more. Netflix's contract with Starz expired at the end of February. As a result, Netflix has lost a sizable number of titles in its streaming library. By April (not included in Q1 but will be reflected in guidance for the rest of the year), Netflix has seen a drop of more than 10% in its Google search volume. As can be seen on the chart, this is a very alarming sign. It wasn't the case when Netflix was growing its number of subscribers prior to 2011. Based on this, I expect Netflix report an OK earnings number, but issue a warning for the future.

There is a decent chance that we will see a sizable drop of Netflix's stock price to the lower bound of its $65~$95 price range estimated above. This gives investors a good opportunity for a short term play using either stocks or options today and tomorrow.

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