Tuesday marks the unofficial beginning to earnings season. When Alcoa Inc. (AA) issues its first quarter report after the close, it will touch off one of the most important quarterly earnings periods that the market has seen in years. Why is this quarter so important? Well essentially, investors will be looking for fundamental proof to help back up the latest rise in stock prices.
As traders, it is important to know which companies are the most likely to bring surprises which move stock prices. Surprises can come in the form of different earnings numbers, but more often come as a result of management issuing different guidance than previously expected. And this brings up a difficult question: What exactly are investors expecting from each stock?
Netflix Inc. (NFLX) offers us a prime example of a stock whose investors are expecting great things. Since its October low of $17.90, NFLX has climbed 151% hitting an intraday high of $44.90. That’s astounding in any market, but especially impressive considering how difficult the last two quarters have been.
The strength of the stock stems from the success Netflix has had in signing up new customers. Many consumers have used video rentals as an inexpensive alternative to more pricey entertainment. In the fourth quarter alone, Netflix added a net 718,000 subscribers. And since the company’s costs are relatively fixed, much of the revenue from these additional subscribers flowed directly to the bottom line.
The Short Case for Netflix
It may surprise you that with so much strength in a difficult economy, I am actually suggesting a short position on this stock. But as we gear up for the earnings report later this month, I expect any surprises to be on the negative side. When you have a stock trading at such a high price as Netflix, any disappointment can lead to very large drops in the stock price.
To understand the bear case, let’s first look at what bullish analysts are expecting:
- Subscribers: While management issued guidance for 10.1 to 10.3 million subscribers at the end of Q1, Barclays is generously placing expectations at 10.324 million
- Revenue: Guidance from the last conference call pointed to $387 to $393 million in revenue. Barclays advises clients to expect the high number at $393 million.
- Earnings: Finally Netflix told investors to expect $0.25 to 0.33 for earnings in the first quarter. Barclays has published expectations at $0.32 which is certainly at the high end of the range and may or may not be optimistic.
Now whether these numbers get hit is really just academic. The point is that investors have extremely high expectations for both the first quarter and for the entire year. That is why you see the stock trading at 30 times the reported earnings. It would seem that even if the company reiterates the current guidance, the stock would still fall because investors are disappointed that guidance was not raised.
Looking further down the horizon, there are a few situations that could arise and challenge Netflix:
- Profit Margins: At this point the company enjoys relatively low costs for the video content. But if studios begin to push the cost of content up, it could quickly cut into the profitability measures.
- Competitors: Currently there are a few smaller players that offer similar video rental or online streaming solutions. But the cost of entry into this market is very low and a new competitor could arguably begin to cut into NFLX’s market share and steal customers away.
- Cost of Customers: Right now it costs roughly $26.67 per gross additional subscriber. Now gross additions are very different from net additions. As customers cancel subscriptions, the net number (718,000 last quarter) can be very different from gross (2,085,000 last quarter). So these costs to add subscribers could become a drain on earnings.
- Exclusive Agreements: Netflix continues to seek agreements for distributing their media through specific devices. So far the Roku and TiVo platforms have agreements through Amazon.com (AMZN)’s digital offering, and more deals could pressure Netflix.
Barclays is expecting the next three years to bring 15 to 20% annualized growth which makes a 30 multiple a bit hard to rationalize. So at this point I believe there is enough risk in NFLX to short the stock, or potentially to buy puts. As always, traders should use discipline and have an exit strategy if the stock moves against them. Use caution, but don’t be surprised to see this stock lower in the coming months.
FD: Author does not have a position in NFLX
NFLX Notes
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April 7th, 2009 at 5:24 pm
I’ve only started watching this one, but I think there may be more at work than you are looking at. For one thing Investor’s Business Daily, a bible to some, has been touting it recently, and had it as a buy this week. IBD is big enough for this sort of thing to be self-fulfilling.
Bill O’Neil has a good strategy that completely ignores high PE ratios, and believes in buying high and selling higher. His rules do work better in a bull than in the current markets…but they do work. The numbers O’Neil looks at for Netflix are really good…and anecdotally, a lot of my neighbors are cutting things like expensive cable and getting Netflix instead…Including the ones living in mansions who don’t turn white when you mention credit card debt.
I’m not sure I’d go either long or short on this one right now. Chart doesn’t look right for either, frankly, according to my way of trading (very aggressive, usually try for 10% or more in a few days in any position). Sure did well in the last couple market drops, which is significant — it’s not being dragged around by the market as a whole, something to watch.
It’s the cheapest way to get movies now — and cheap is IN (see economy). If you like to wast time watching movies, they are the go-to guys at the moment. Any real competition will take awhile to make any difference.
Note, as I said above, I don’t have a position in this either way, but AM looking at it pretty hard for any sign the time is right — for either short or long.
April 7th, 2009 at 10:21 pm
Hey Doug,
I’m actually a big fan of IBD and William O’Neil. I cut my teeth on his trading style and agree with about 90% of what he says. In some ways, I think NFLX stock success can partially already be attributed to the high rankings IBD and other growth stock services have given. Self-fulfilling may in fact be the correct term.
However, I also think that you get to a point where PE ratios actually do eventually matter. And in this economy and in this market they matter much more quickly than in a raging bull market. I understand that NFLX has a strong business. As a COMPANY they are firing on all cylinders. But there’s a difference between a company and a stock. Stocks can rise or fall on many other issues besides company strength (ironic isn’t it?)
Regarding the chart, you may be right. There is certainly risk either way. I want to point out that risk to those long the stock because it could be a dangerous holding. I could be early and we could see another 10 or 20% move. That may be a good argument for buying puts instead of shorting outright (but that’s so much more expensive). Still, gun to my head, I would say the next 20% move will be down not up.
Regarding the cheapest way to get movies – you should probably rephrase to “its the cheapest LEGAL way to get movies now.” There are more and more alternatives and competition (even legal competition) could quickly creep in.
Not trying to sway your opinion. Honestly I really appreciate the thoughts and the chance to bounce some ideas back and forth. Thanks for the comment!
Zach
April 9th, 2009 at 12:53 pm
Due to the huge movement up I’m now pretty exposed to NFLX. In normal circumstances I know I should pare some of my position, but I’m not. I look at NFLX and I see the type of company that becomes a 2 or 3 bagger from where we already are.
1) Consumers are buying less DVDs and renting more. In Disney’s Q1 conference call they were unable to explain weak DVD sales and hypothesized that people simply don’t want to buy DVDs anymore. I’ve been feeling the same way. The average collector owns 80 DVDs. I own many more than that and I often look at my collection and wonder why I spent so much money on it. Renting is a much better value proposition. In this economy that preference is really being pushed.
2) The quality of Watch Instantly is improving. Again, just personally speaking, but my Instant queue used to be 8 titles or so; now I have 70+. Lots of great classics and tons of TV content (NBC shows, the BBC Office and South Park). Improving quality means less churn.
3) Blockbuster is dead in the water. It just makes no sense to drive a two ton vehicle to Blockbuster, manually pick out a title and drive the one ounce disc back home.
NFLX’s earnings report is going to be very interesting to watch. But with ever improving service I’m not fearing it.