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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Allegiant Travel Company (ALGT) has a leg up on its competition.  While airlines like UAL Corporation (UAUA), AMR Corporation (AMR), and Delta Air Lines, Inc. (DAL) are cutting back on the number of flights offered, Allegiant is actually adding new routs and growing profits quite impressively.  The stock has been a strong performer in the ZachStocks Growth Model which currently has an unrealized gain of 23% in this position.

The strength is primarily due to the company’s decision to keep fuel costs unhedged.  While this strategy can certainly add some volatility, the most recent trends in fuel prices have certainly benefited ALGT.  Currently the economic slowdown has carriers who cater more towards business travelers feeling the pinch.  Not only is business travel slacking, but lower fuel costs don’t have as much of a positive effect.  That is because hedges at much higher rates now register losses.

Allegiant has taken some strengths from the famous Southwest Airline playbook.  Both firms strive to be the low-cost provider and are willing to cut corners in order to make each ticket affordable to customers.  Allegiant does not serve free snacks, and even charges extra for priority boarding and coveted aisle seats.  But the strategy pays off as customers continue to book flights regardless of the economic backdrop.  In an interesting side-note, one analyst I read speculated that $33 of the average $107 per ticket is from these ancillary fees.

While large hubs may be profitable for competitors such as Delta, Allegiant has decided to stick to small, off-the-radar locations in the Northern United States.  Destinations are primarily vacation getaways such as Las Vegas, Phoenix, Ft. Lauderdale, Orlando or Tampa.  Since the company sticks primarily to small hubs with little competition, it usually enjoys relatively strong pricing power and avoids bidding wars.

Another strength for Allegiant is additional revenue from referrals.  Similar to Expedia Inc., Allegiant offers deals on hotels, car rentals, and attractions like theme parks or sight seeing.  This helps to diversify revenue should fuel prices cut into profits in coming months.

One tactic the company uses to combat rising fuel costs is to cut the number of flights.  But currently the low oil prices are the primary driver of the company’s success.  In December, the average fuel cost per passenger was $30.  This compares to roughly $60 in the second and third quarter, and $55 in the first quarter of 2008.

Allegiant boasts a very healthy balance sheet with nearly $175 million in cash and short-term securities (as of Dec 31).  The company used cash flow to pay down debt from $70.1 million at the end of the third quarter to $64.7 million at year end.  The goal is to get debt to near $25 million by the end of 2009.  At the same time, the company’s board has approved a new stock repurchase program of $25 million.  While the company has no contractual obligation to actually go through with repurchasing the shares, it appears management is making wise decisions with capital to benefit shareholders.

based on expectations for this year and next, the company is still trading at a relatively attractive multiple.  Analysts are forecasting $4.16 for 2009 and $4.27 for 2010.  And yet the stock holds a forward PE of just over 11.  I believe the stock still represents an attractive opportunity as a rebounding economy could push earnings much higher than expectations.

FD: Author has long position in ZachStocks Growth Model
ALGT Notes
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One of my favorite trading stocks is making quite a strong move today.  IntercontinentalExchange, Inc. (ICE) is up sharply after Goldman Sachs added the company to its conviction list.  This exceptional endorsement comes on the heels of monthly futures data which were released on Thursday.  The data shows that ICE is not only surviving this economic downturn, but actually gaining new business and operating from a position of strength.

ICE approaches trading and clearing a bit differently from its competitors.  The company is primarily focused on OTC (Over the Counter) contracts specifically geared toward the energy trading markets.  While ICE has worked hard to diversify its product offerings, the company still benefits from strength (or even from volatility) in the oil and natural gas markets.  Since these markets have been more active in recent weeks, ICE is seeing trading volumes pick up and profitability increase.

One of the issues that plagues competitors like CME Group Inc. (CME) and NYSE Euronext (NYX) is pricing.  As more trading firms try to gain market share, the inevitable price war can bring profit margins down quickly.  But Goldman reported that they see pricing holding up relatively well for the contracts traded by ICE.  This is largely a benefit of the company choosing a niche and executing well in a specialized market.

Looking towards the future, it appears ICE has several important opportunities that could continue to drive growth.  As Credit Default Swaps (CDS) contracts begin to trade again, and banks look to unload or reorganize these toxic assets, ICE could be a major participant in clearing these trades.  There is also a good chance that the new proposed Emissions Cap and Trade system will be a strong catalyst for growth.

ICE is certainly not as cheap of an investment now that the stock has rallied from the low 50’s to the high 80’s.  But at this point, it looks like much of the risk investors were fearing is now in the rear view mirror, and potential to increase profit lies ahead.  Analysts are expecting the company to earn $4.20 this year and $4.96 in 2010.  That means the stock is trading at a multiple of roughly 20.

Normally I would begin to be concerned at this level.  But if one or two of these new markets begins to add marginal profits to the company’s strong base, the earnings picture could rapidly change and the high multiple would quickly become conservative.

On a technical basis, the stock appears to be breaking out of a long-term base and as volume picks up it becomes clear that institutional buying is coming in.  I would recommend purchasing ICE over competitors at this time although I like the entire industry and believe the next few quarters should show strength in these markets.

FD: Author has a long position personally and in the ZachStocks Growth Model
ICE Notes
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What do you do with a stock that refuses to rally even in the face of a 20 some-odd percent gain in the market?  The answer is to Short It! There is a common sense trader’s assumption that if a stock can’t participate in a strong market, it will become even weaker when the market quits going up.

Now I’m not one to take cute phrases at face value – or to short a stock based solely on the chart pattern, but for American Public Education (APEI) we have enough negative issues stacking up to create a good argument for shorting the stock.  And it helps to realize that the market is confirming that APEI is not an emerging leader in this rapidly advancing market.

Looking into the fundamentals of this company, it is tough to call this a “lagging business.”  The online educator boasts 45,000 students representing all 50 states and 130 different countries.  Earnings have grown tremendously since the IPO in 2007.  In fact, Zachstocks covered APEI shortly after the IPO with positive expectations.  But that was during a strong market period where investors were willing to pay huge premiums for exiting stories…  I don’t have to tell you that times have changed.

Currently the stock is trading near $43 while the expected earnings for this year is $1.20.  That means investors are willing to pay $35 for every dollar that the company earns.  Why would you pay so much?  Well, its because investors have been programmed to expect the company to beat estimates and to grow by huge percentages each year.  While this strategy works incredibly well in a bull market, its a dangerous game to play when times are more difficult.

Imagine for a minute that the company has difficulty adding new students.  Maybe federal (or private) loan programs are reduced or require more documentation.  What if the company announced that instead of $1.20, the company would only earn $1.00 per share this year.  That’s still a good thing right?  It would still represent a 6% increase over last years earnings.  Not too shabby considering the environment we are in right now.

But the problem is that the stock price is implying huge growth.  That’s why investors pay 35 times earnings.  If that huge growth is gone, the multiple investors are willing to pay will also go.  We could be generous and say that the new multiple would still be 20 times earnings.  But that would leave us with a stock price of $20 – or 53% below the current price.  That’s a pretty scary scenario – and not that far fetched either.

In the past month we have made significant gains in long opportunities.  Shanda Interactive (SNDA) is actually up 53% since we recommended the stock in January.  Similar gains have been made in Continental Resources (CLR) and LDK Solar (LDK).  We have several Long Ideas that continue to make money as the market climbs.  But it is important to have some defensive plays on the field as well.  And stocks like APEI which are expensive, but not participating in this rally make for great short candidates.

FD: Author does not have a position in APEI

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