The Rise and (Likely) Fall of Netflix

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

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16 Comments on The Rise and (Likely) Fall of Netflix

    • Yes I absolutely agree with the premise to next earnings. I have seen “Is everyone in.. let the pain begin”. Like your observation and have been rewarded tremendously through such scenarios in the past. yes next Q will break the camel’s back :)

  1. Love Netflix but some medium term puts looked irresistibly attractive as of today. Yes the company has performed beyond well but the share price is a disconnect now. The repeat of beyond nosebleed highs is too much to continue with faith in the “imagine the possibilities” momentum that’s been at work

  2. What drives any market are longs and shorts and there were/are a lot of shorts with regard to the Netflix stock and it is the short sellers and continued short sellers that will end up holding the stock price up as they scramble to buy back the shares, any 2.5-5 % market drop in the share price there will be short covering. Wall Street Dow Jones is down apprx -160 points today and with that you would expect Netflix to retrace. What does the Netflix stock do ? It goes up 7% to a record closing price, on a friday which shows that some distressed shorts were trying to close and buy back their positions for the weeks close.

    NETFLIX CEO TAKES ON SHORT SELLERS.

    http://www.theglobeandmail.com/globe-investor/markets/markets-blog/netflix-ceo-takes-on-short-seller/article1844845/

  3. This article mentions Google TV as a competitor to Netflix. That’s not true (yet, at least). Google TV is currently a *distributor* of Netflix, as one of the handful of apps that Google TV currently ships with is the Netflix app. This will probably remain the case for the foreseeable future, as Google’s move with GoogleTV is to become the ubiquitous content-stream aggregator. They’re not looking to buy and resell the content from the origin producers as Netflix does.

    Netflix and GoogleTV are totally different and complementary businesses. If GoogleTV gains significant traction, Netflix will be boosted as well.

  4. I think the “catch-up monkeys” need to really consider if a drop in marketing and effective tax rate are cause for “very strong results”… This type of behavior truly makes me wonder. I can understand the short squeeze, but having analysts rush to upgrade just makes no sense.

  5. This is to add to what Robustus said. The same is true of Apple TV, it too can stream Netflex content. Thus increase sales of Apple TV will help NetFlex.

  6. Oh please! Give it up already! Anyone listening to you so-called pundits last year would have missed out on ALOT of money! It’s been a nice fall UP for me!

    Get it through your heads… NetFlix is ENTRENCHED already. They’re in DVDs, PlayStations, X-Boxes, Wiis, Rokus, and a good amount of plasmas and LCDs. They can’t just be ripped out and replaced. And most NetFlix subscribers LOVE NetFlix. Good luck with your short… I’m betting in the other direction.

    I bet you though iPods were a fad and “predicted” Apple’s demise too, huh?

  7. No one left to buy? It’s a $11Billion MCap stock. When there’s no one left to buy AAPL at $300Billion, then this might be a factor. Also, Netlfix vs. it’s competitors is like a tank vs. girl scouts armed with nerf guns. What did you guys do with your report saying to sell at $60/share??

  8. The greatest concern for Netflix:

    When ISP begin charging extra fees for excessive downloads.

    The days of purchasing unlimited downloads will be over soon I suspect and watching video content continuously over the web will become more expensive.

    Netflix is free riding on the internet instrastrure currently in place which may or may not be capable of withstanding tens of millions of people live streaming their tv all at once.

  9. Perhaps there are things about Netflix’s business that you aren’t aware of. You should invest time in watching this.

    Netflix’s Move to AWS

    Adrian Cockcroft, Cloud Architect at Netflix, discusses Netflix’s move to the Amazon Web Services cloud computing environment. Presented at Cloud Computing Silicon Valley Group.

    meeting announcement
    http://www.meetup.com/cloudcomputing/calendar/14476942/

    video
    http://blip.tv/file/4252897?filename=CloudSVgroup-NetflixsMoveToAWS962.mp4
    (audio starts after a few seconds)

    slides
    http://www.slideshare.net/adrianco/netflix-on-cloud-combined-slides-for-dev-and-ops

    Nuggets of business info are sprinkled throughout, especially in the Q&A.

  10. The fall of Netflix???? What are you smokin crack. Netflix is 8 bucks a month here in Canada. The average hd cable package is around 60 a month. movie bundles are $14-$25 a month on top of that with most of the same movies that are on Netflix. Trust me when I say they have only begun. First mover with great marketing and branding. For $2 a week you would have to be retarded or a real cheap f*ck not to subscribe. Netflix is a great stock and it always has been. The rise and fall of wallstreetpit.com sounds like a much better article!!!!!

  11. In the Whitney report there were some overlooked items.

    The catalog is described as “weak,” but what does that mean really? If that is accurate, then he is right to be confused by the seeming lack of subscriber reaction to it.

    When I read “weak” in the context of NFLX I think of titles that are low box office, but distinctly thoughtful, dangerous, slow paced, contemplative, difficult topics, complex plot lines, unusual main characters, documentary, historical, cinematic-ally wonderful, musically wonderful, scientific, political, silly, cult faves, side splitting, intellectually provocative, foreign sub-titled, animated, etc. I can think of several fits to each of those categories that I will watch more than once. Simply put, I don’t really miss the popular blockbusters – maybe, weak isn’t accurate to many of us, it is part of the secret allure?

    I know plenty of people who are equally disappointed with TV. And for whom a $30 (ticket, gas, soda, popcorn) solo trip to a first run movie seems weird. Wouldn’t I rather cook a really nice meal and hang with my wife – and watch something on NFLX? For less money and a beer?

    Also the GUI is getting better. There is more information, and the heuristic video genome software works; it is regularly showing me more movies that I am indeed interested in. It now has a similar appeal as Pandora in its ability to suggest potential titles I may like.

    There are so many titles. If I don’t like how one is going I can scoot ahead, or stop it and try another.

    The GUI experience has become a bit of fun in itself.

    I honestly would not trade this for box office winners.

    I pay for the one disc and streaming option. I still have a queue of DVD’s, but I am not very concerned with then anymore. They tend to languish.

    Bandwidth is a little dodgey because TW is kind of expensive and slow. It is irritating me when it bogs dawn a bit. I have more trouble when my antivirus scan runs or my home server runs a backup.

    I don’t want to pay more, but I would. I would pay per view for these titles. I wont’ take cable because they don’t offer PPV. I wouldn’t use it other wise. Broadcast TV turned out to be a problem. 25 miles out from the town means I get worse reception than before the death of analog. NFLX has me completely hooked and if it when away or too high in cost I would go back to radio, reading, and NFLX DVDs.

    Hastings isn’t kidding about evangelists. But they come for a really good product not a weak one.

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