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Alex Cho is a top contributor on Seeking Alpha in both the long ideas and technology section of the website. Alex Cho's articles have been featured on The Motley Fool, The Street, and Benzinga. Alex Cho has been featured on ValueWalk's throwback Thursday for his analysis on Apple. Furthermore,... More
  • Short-Term Netflix Trade? 0 comments
    Oct 25, 2013 8:37 AM | about stocks: NFLX

    Upon first examination of Netflix (NASDAQ:NFLX) and its 3rd quarter report, I have to admit, I really was not that impressed. The stock has been an exceptionally phenomenal investment vehicle over the past year. In December of 2012, I was enigmatically optimistic in the company and offered valuations that seemed absolutely absurd at the time. But in the real world, the crazy people tend to get a lot of the glory, and I have to admit, being crazy tends to have its perks.

    This article is going to be extremely time sensitive, and I believe the window of opportunity for acting on an opportunity like this is extremely limited. Therefore, I want to reiterate that this is perhaps risky, and only hard-core traders will want to sell-short over a short-term time horizon.

    So we want to time the stock market

    Usually, when there is panic selling, a stock collapses in a relatively short period of time. Sure, Netflix management came out reporting some pretty decent guidance. But it wasn't good enough to justify the current valuation. Now, I know if you look ten-years out into the future, we're talking about a fairly compelling investment opportunity. But even so, in the immediate present, is Netflix worth a 284.9 price-to-earnings ratio? Not really, more specifically, the market will eventually change sentiment, and that time is now.

    Often, we refer to the stock market as a voting machine. Whoever gets the most votes wins. Now, back at $80 I liked Netflix, even at $200 per share. But at $338 per share, we're really starting to push it, and anyone who has observed rubber knows that when it's stretched enough, and released, it snaps back into place. Likewise, stocks that overly expand in valuation snap back into a "fair valuation." This phenomenon is extremely common, and we can observe this using the Netflix chart.

    By measuring one-week of price movement using Y-Charts data, I was able to pinpoint the exact percentile change and compare it to the recent volatility in the price of Netflix. Now phenomena in nature tend to repeat, and this is one of the most coveted techniques amongst world-class technical traders. Observe very closely, and never forget this method.

    (click to enlarge)

    Source: Freestockcharts

    Anyone who remembers trading Netflix back in September of 2011 remembers the infamous 40% price drop in a span of a single week. The drop resulted as the company's business practices led investors to question whether the business would be able to grow over the long-term. On September 14th 2011, Netflix was trading at a more reasonable, 46.54 P/E multiple. Again, we're not in the same exact position this time around, but if we were to quantify the valuation of the stock, we could come up with a pretty reasonable excuse to short the stock for the rest of this week, and hope to generate returns from the excessive volatility in the stock. Assuming, the volatility continues for the duration of the week, we can easily see the value drop by 30-40%. Furthermore, a drop is a series of down days, implying that it's practical to anticipate a continued decline in the value of the stock for the duration of the whole week.

    Some quick insights on Netflix

    In the 3rd quarter, total membership figures grew to over 40 million members, and the contribution margin was able to improve by 6% year-over-year in the domestic streaming segment. In total, the company was able to generate $701 million in revenue in the quarter, and was able to generate both quarter-over-quarter, and year-over-year growth. This implies that growth is accelerating towards the end of the year. However, just because you see growth accelerate doesn't necessarily mean that the price-surge in the pre-market and after-hours trading was even justified. Sure, it's a low liquidity market, and I'm sure if a couple overly humongous bids were thrown around, you could fake the tape. So going into the earnings announcement, I started buying some out of the money puts. Again, I can sniff skunk from a mile away, and this is just one of those stories that get good, but too good to be true.

    One of the most important metrics to measure a company by is its sales growth. In this instance, the company was able to grow revenue by 22% year-over-year. This rate of sales growth, plus some cost cutting couldn't generate the type of net income growth the stock is priced for. Sure, I'm going to be generous and offer a fairly high valuation compared to other analysts. But, I won't agree with the market at $330 per share!

    Currently, analysts on a consensus estimate that Netflix will grow earnings by 22.5% per year over the next five years. This rate of growth seems reasonable and a little conservative by my own estimates. But let's run with it. Because, if we look at this figure we can at least come up with our own expectation in comparison to what the rest of the street think the stock should be valued at. The reason for the modest 22.5% earnings growth figure is because analysts on Wall Street are dubious of Netflix being able to generate higher gross margin figures. The cost of content licensing has gone up, and while the number of competition is somewhat limited due to the scope of the streaming market, there's no denying that Netflix needs these content publishing houses more than they need Netflix. Sure, it's great that Netflix can operate at greater economies of scale, which reduces the average cost of content, but significant improvement in margins won't happen for quite a while. So we can rest easy over the short-term and ride this pony a little downhill.

    Furthermore, because growth isn't expected to be phenomenal, in comparison to the 279.3 price-to-earnings multiple, investors should be closing out their positions for what has been a very generous year for Netflix shareholders. This reminds me of spam, "congratulations you just won." Now close the pop-up and move on.

    Moving onto the forecast

    Okay, this method of mine is proprietary, and the fact is, it's so complicated! I couldn't thoroughly explain it in a way that makes sense. I can only solve it using a computer, meaning that it cannot be done by hand unless if you were a walking human calculator that can calculate numbers at six sigma. Since you can't, and I can't let's just focus on the task at hand.

    Currently, I acknowledge that Netflix is generating substantially high rates of growth. It's reasonable to say that the company may merit its valuation, but it doesn't deserve it currently. We should expect the stock to grow into its current valuation further down the road.

    (click to enlarge)

    Source: Alex Cho

    I currently expect earnings of $1.52 in 2013, and $4.93 in 2014. The rapid earnings growth is an increase in the number of members, paired with better gross margins due to greater economies of scale. Following 2014, I expect earnings to grow at around 30% on a compound basis. I will offer a more exact calculation, and create a more thorough forecast on EPS. But for our purposes, worrying about 2015 isn't really what we're after. Let's look closer to 2013, and the price forecast.

    (click to enlarge)

    Source: Alex Cho

    Currently, my upper bound forecast is $271 per share for Netflix, with the lower bound at $136 per share. Now usually, in any instance a price forecast is made, analysts often have to readjust, well I'm not readjusting my forecast at all for the rest of 2013, unless something changes with the fundamental picture.

    For now, I feel confident that Netflix will trade at around $270 per share by the end of the week, given the immediate volatility, and the impossibility of growing earnings enough over the short-term to merit a higher valuation over the short term. Therefore, I believe that Netflix stock may not necessarily decline like it did in 2011 by 40% in a single week. What we're looking at is a price decline in the range of 16.6% to 58.2% from $325.42 per share. Investors may see this as a buying opportunity, but traders can use this time of momentary volatility to short the stock for a couple days for a hefty annualized-return.

    Conclusion

    From current levels ($325.42 per share), if investors go short, I expect a return in the range of 16.6% to 58.2%. Of course, I'm a little dubious of a return that's as generous as 58%. But definitely expect volatility in the week ahead, and more selling. A reasonable exit point is anything below $270 per share.

    Also, for those who are a long-term investor. Buying the stock now is a disastrous idea. Usually, when a stock pulls back, it tends to decline in valuation over the course of 3-5 days. Sometimes a stock can decline for years. Of course, with Netflix it was just a miss in expectations, so if anything, the decline in price will be a momentary correction before the valuation starts to stabilize.

    Since this is the first down day for Netflix, investors should wait a couple more days before attempting to buy into the dip. The future is bright, but it's not going to be reflected in the price of the stock for quite a while.

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

    Stocks: NFLX
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