Name That Trade – $NFLX: House of Cards

by Dan October 14, 2015 11:27 am • Commentary

Event: Netflix reports Q3 results tonight after the close.  The options market is implying about a 15% one day move, which is shy of the 18% 4 qtr average move, and rich to the 10 year avg of 13%.  The last two quarters the stock has broken out to new all time highs following results. To add some context to the implied move, last quarter the options market implied a 10% move, and got an 18% move.  Option market makers aren’t taking any chances this time around.

I would also note that over the last 4 years the stock has declined on average nearly 19% on its October Q3 report (just saying):

from Bloomberg

Price Action / Technicals: NFLX is up an eye-popping 127% on the year, but down about 15% from the all time highs made in early August.

As my Options Action friend Carter Worth likes to say, draw the lines anyway you want… the way I see it is fairly simple.  The April breakout from $70 to new highs yielded a nearly 100% gain into its August highs.  Since then, the volatility bands for the stock have dramatically widened, suggesting the stock is setting up for a breakout one way or the other above the recent downtrend, or below the uptrend that has been in place since early January:

[caption id="attachment_57644" align="aligncenter" width="600"]NFLX 2 yr chart from Bloomberg NFLX 2 yr chart from Bloomberg[/caption]

Expectations:  Last night on CNBC’s Fast Money Wedbush analyst Micahel Pachter, (a noted bear on the stock who maintains a $40 price target) suggested that last week’s announced price increase for new subscribers was “a bit sinister”. He thinks company will use it as excuse for why domestic subscriber additions will be down in the December quarter. Watch here:

Estimates from Bloomberg
-3Q GAAP EPS est. 7c (range 7c-9c); co. forecast 7c (July 15)
-3Q rev. est. $1.75b (range $1.71b-$1.77b)
-3Q domestic streaming net adds est. 1.23m (avg 6 ests., range 1.15m-1.46m) vs forecast 1.15m
-3Q intl streaming net adds est. 2.44m (avg of 6, range 2.4m-2.5M) vs forecast 2.4m

-4Q GAAP EPS est. 4c (range loss 13c to EPS 15c)
-4Q domestic streaming net adds est. 1.94m (avg of 3)
-4Q intl streaming net adds est. 3.31m (avg of 4)

Our Take: Valuation is out the door. It is not a reason to sell the stock, and certainly has not been a reason to avoid owning the stock.  I would note that the stock has gained more than $25 billion in market cap so far this year, a year that the company is only expected to gain $1.3 billion in sales year over year, a 24% growth rate, while earnings are supposed to decline by 45% (albeit from a very low base).  The company is spending on original content as it’s imperative to maintain their domestic subs. They are also actively expanding overseas where all of their future growth is expected.  In the quarter NFLX is expected to add 1.15 million net domestic streaming subs and 2.4 million net new international streaming subs. This on a base of 42 million in the U.S. and 23 million internationally.

The bear case (excluding valuation) is fairly simple.  Competition, and there is a ton coming on line for streaming services. I suspect when Apple finally gets their act together on some sort of video subscription service through iTunes, then the short is on. In the meantime, I think there has not been enough investor focus on NFLX’s emerging original content competition which was evident in the Septembers Emmy awards. Amazon.com was this year’s newcomer, which clearly stole some of NFLX’s thunder. From Forbes.com:

Last year, Amazon’s streaming video service received a grand total of zero Emmy nominations, compared with 31 for Netflix.

This year, Amazon AMZN topped the award tally of its streaming rival by taking home five Emmy statues despite having roughly one-third of the number of nominations Netflix NFLX did. Netflix won four Emmys last night after being nominated for 34 awards, while Amazon only received a dozen nominations, but still walked away the biggest winner among the streaming services.

And HBO continued their domination, also from Forbes.com:

it was a huge night for HBO, which owned by Time Warner TWX, as the premium cable network led the TV pack with a whopping 43 Emmy wins after scoring triple the number of nominations of its nearest competitors (126 Emmy noms for HBO, compared to 42 for ABC). The Emmy runner-up to HBO was NBC CMCSA , which won 12 statues — the same number taken home by the HBO’s “Game of Thrones,” which won for best drama series and set a record for the most Emmys awarded to any series in one year.

So what’s the trade?

Hypothetical Bullish: targeting average post earnings gain the last three quarters: If you think the stock is going to do what it has done the last few quarters then play for a breakout and buy out of the money weekly call spreads or maybe even a call fly. With the stock at $109.30 the Oct 16th 120/130/140 call fly is offered at 1.50, offering a break-even 121.50, max gain of 8.50 at 130 (up 18%, the avg gain the last 3 quarters), gains of up to 8.50 between 121.50 and 138.50. Losses of 1.50 below 120 and above 140.

Hypothetical Bearish: Let’s say you want to play for the big one and are inclined to target the August lows (near 85).  Options prices are very high. An out of the money put spread like the Dec 100/8o is offered at $5.50 (with the stock at $109). Break-even is 10% away. But this is a very poor way to use options to make a directional bet. So you could consider selling an upside call spread to buy the put spread in a premium neutral fashion and risk the width of the call spread to finance the purchase of the put spread.

In NFLX, playing for the big one has been a fools errand.  For those intent to do so, it probably makes sense to figure out how much you are willing to lose and buy very near the money weekly puts. If the stock is going to go lower it will be on an earnings event and it might be big, but know you are merely gambling on direction as it could go the other way.

As always we will offer the usual disclosure about short dated earnings trades, you need to get a lot of things right to merely break even, direction, timing and magnitude of the move. In a name like NFLX where options prices are insanely bid, it makes the profit proposition that much more challenging.