Our big prediction for 2011 is playing out perfectly.
In our only big prediction for 2011 we wrote:
Netflix (NASDAQ:NFLX) will post some blow-out results in January when it announces its latest financial results.
We could see Netflix shares rise from $180 to $220, $240 or more as the positive “surprise” will turn the final non-believers into believers.
Yesterday it happened. The Wall Street darling posted very strong results from the last quarter of 2010.
Netflix added a record number of subscribers. Earnings were up. Margins were up. Interest in Netflix is up too. Its shares jumped from $183 yesterday to more than $210 today.
Analysts are jumping over each other to upgrade their ratings. Bank of America, Morgan Keegan, Think Equity, and Pacific Crest have all upgraded Netflix.
No surprise here really. All the signals of a big quarter were there for Netflix.
It ran a great advertising campaign for the holiday season.
It has hit critical mass. Netflix has added more subscribers in the past six months than it did in its first six years.
Its leadership position has allowed it to expand its content line up.
Netflix seems unbeatable at this point. And that’s’ exactly why it’s almost time for the high profit potential second half of our prediction.
Netflix: It is Not Different This Time
Our Netflix prediction is playing out according to the playbook which has befallen so many stocks in the past.
Great results. Analyst upgrades. Investors who waited on sidelines for a dip are capitulating and buying now regardless of price.
This is good news in the short-term, but odds are its going to create problems Netflix shares over the next few weeks and months.
From a fundamental perspective, Netflix is facing a few headwinds in the near-term:
Increased Competition: Hulu.com, Google TV, and Apple TV are aggressively battling for market share with Netflix. They are legitimate contenders too. They all already have a beachhead established on the end market for online content delivery.
Higher Costs: The content owners which provide it to Netflix are going to ask for a bigger piece of the pie. And given Netflix’s rising revenues and increasingly lucrative offers from a growing number of deep-pocketed competitors, the content providers are going to have a lot more leverage to renegotiate royalties. That’s going to cut into to Netflix’s margins.
International Expansion: Great for the long term, but challenging and costly in the short-term.
All kinds of companies have tried going international with varying degrees of success. Dell Computer’s foray into Germany is the perfect example what inevitably happens to really successful companies when they reach beyond U.S. borders.
Dell began an aggressive TV advertising campaign in the 90s in Germany. Dell gave a toll-free number to call in at the end of the commercial. Almost no one called and Dell lost a lot of money on the campaign.
It took months for Dell to learn that the majority of Germans did want a customer-built computer at a lower price, but they wouldn’t call in. The majority of Germans, however, would send a fax requesting someone from the company call them.
It was a cultural subtlety that Dell missed when designing the ad. After Dell just asked for interested viewers to send them a fax, its sales in Germany soared.
This happens all the time in international expansion. Netflix will likely run into similar, unexpected speed bumps just like most other companies that have gone international.
Those are just a few of the known potential pitfalls. There are plenty more unknown ones which inevitably sneak up during periods of aggressive expansion.
Over time, these will likely be viewed as small hurdles. Netflix can and likely will beat them in time and continue to grow. But that’s not going to matter much to an ultra-short-term focused Wall Street.
What Happens when there is No One Left to Buy?
Netflix’s growth has been parabolic. Its surging subscriber base, revenues, and earnings have been consistently beating Wall Street’s expectations.
The serial success has pushed expectations are so high for Netflix, Wall Street expects even more stellar numbers going forward. As a result, the risk of not growing fast enough are extremely high.
The risk/reward has shifted completely as Netflix shares will likely become a victim of their own success.
For example, if it beats expectations next quarter, great. Shares may jump 3% to 5% or so.
If it merely meets expectations, you can expect a 0% to 5% drop.
If it misses the extremely lofty expectations, the floodgates will be opened. Netflix shares will be in for a steep drop.
Basically, what we see at this point is a situation where anyone who wants Netflix shares has already bought them. It’s the old Wall Street saying in action, “Is everybody in…let the pain begin.”
As part of the second leg of our prediction, Netflix shares will continue to rise leading up to the next quarter. Expectations will grow right along with them. A correction will start right after the next quarterly results and with a company.
And the key to success with this trade is the same key to our successful investment philosophy.
If we’re right and the rug gets pulled out from under Netflix, the shares with a P/E ratio of 80 and very few potential buyers left on the sidelines are going to fall quickly. This is the type of situation where a high-flyer easily gives back 20%, 30% or more in a matter of a few weeks after the not-as-good-as-expected news is announced.
And if we’re dead wrong and Netflix posts another great quarter, shares jump a 3% to 5% after a blow-out quarter, we’ll take a small hit and move on.
We don’t have a crystal ball. No one does. But we can spot a situation where we risk a 5% to make a 20% or 30% gain in a few weeks on a relatively simple trade. And that’s the type of trade that can make you a much more successful investor whichever way the markets go from here.
By Andrew Mickey