NFLX And Gap Fill?

by Dan January 19, 2016 1:12 pm • Commentary• Trade Ideas

Event: Netflix reports Q4 results tonight after the close. The options market is implying about a 14% one day move, which is shy of the 15.5% 4 qtr average move, and rich to the 10 year avg of 13%. To add some context to the implied move, last quarter the options market implied a 15% move, and got an 8% move lower, the first down move in four.  

Prior to NFLX’s Q3 results in October, I made the following observation about the stock’s recent performance after Q3 reports:

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

Looking at the last Q4 reports, the price action following also displays a trend like the last 5 Q3 prints, but this time all up, actually the last seven instances going back to 2008:

Q4 reports % change
date of stock
1/20/2015 17.30%
1/22/2014 16.50%
1/23/2013 42%
1/25/2012 22%
1/26/2011 15%
1/27/2010 23.70%
1/26/09 15.50%

Obviously this doesn’t mean squat, but the fact that the stock has declined the day after the last 5 Q3 reports, and risen on average more than 20% over the last 7 Q4 reports could suggest some sort of seasonal pattern to subscriptions that investors are willing to give more credence during the Dec quarter.

Price Action / Technicals:  NFLX surprisingly has outperformed the broad market, down only 5.5% on the year, vs the SPX down 7.5% and the Nasdaq Composite down 10% on the year, this after the stock was up 134% in 2015.

A quick look at the one year chart shows the stock’s volatility since its July breakout to new highs on greater than expected Q2 subscriptions.  On two instances since the late July breakout the stock has rallied to just about $130 and then retreated to about $100.  Last week the stock bounced off of its 200 day moving average, just above $100:

[caption id="attachment_60378" align="aligncenter" width="600"]NFLX 1yr chart from Bloomberg NFLX 1yr chart from Bloomberg[/caption]

A break below $100 yields little support till $95, and then below that there is an air-pocket to the Aug 24th low of about $85.  A quick look a the five year chart shows the parabolic nature of the move from $60 from early 2015:

[caption id="attachment_60379" align="aligncenter" width="600"]NFLX 5 year chart from Bloomberg NFLX 5 year chart from Bloomberg[/caption]

Volatility: 30 day implied volatility is in the mid 70’s. This is similar to the last earnings report but much higher than the others over the past 2 years (30 day implied vol in red):

[caption id="attachment_60381" align="aligncenter" width="641"]Screen Shot 2016-01-19 at 9.31.16 AM 2 year iv30 vs hv30 vs iv360 from LiveVol Pro[/caption]

The implied vol in Feb is 76, that should come into 50 or lower following the report. That means each option’s extrinsic value will get cut by a third to even a half of its value after the news.

Let’s dive a little deeper into what that means. Out of the money options like the Feb 110 call are entirely made up of extrinsic premium. If the stock closed where it is now (106) on February expiration the 110 calls would be worthless, there is no intrinsic value to them because they are out of the money. So if the stock didn’t move at all on the earnings, those 110 calls that are currently 7.50 at 75 vol would be worth only $5 at 50 vol.

Now let’s look at an in the money call. The 100 calls that are 12.50 now are 6 dollars in the money. That means they have 6 dollars in intrinsic value and 6.50 in extrinsic value. That 6.50 in extrinsic value is the part that gets cut in a third if implied vol goes from 75 to 50. That means that option would lose about 2.20 in value all else being equal with the stock unchanged.

So that illustrates how the pumped vol works into an event. You need to get the direction right, and the magnitude of the move on long premium trades. Because the collapsing vol after the event takes a big chunk out of anything you own.

Fundamentals:  In October, when the company reported Q3 results, investors were disappointed with domestic subs that missed prior guidance and consensus estimates. That came in quarter where the company raised pricing for new customers by $1, which helped revenue per user. Given the onslaught of competition in developed markets like the U.S., international growth will be the main focus, especially considering the company’s announcement two weeks ago that they are launching in 130 countries this quarter.  Last quarter the international subscriber upside large came from new free member signups, it will be very important to see high levels of conversion rates.

I suspect it is too early to get any meaningful data about the international roll-out to new countries but I would expect the company to be honest about expected costs of the roll-out and give some sense for costs associated with original content in these countries/regions.

Key Factors to Focus on from RBC Analyst Mark Mahaney:

1) Subscription Metrics – We are estimating
1.65MM net new U.S. streaming subs and 3.5MM net new International
streaming subs. However, we would note that there is likely a great deal of
uncertainty around U.S. Sub Adds given the Q3 miss and the timing of the
Q4 domestic price increase.

2) Domestic Streaming Contribution Margins
– We are looking for a 34.0% segment contribution margin (up 160 bps
Q/Q and 600bps Y/Y), which implies robust 46% Y/Y growth in Netflix’s
Q4 Domestic streaming contribution profit. &

3) International Losses –We anticipate International contribution losses of $117MM in Q4. NFLX indicated that Q1 losses should also be around $120MM.

My View: Valuation is obviously a useless conversation as the stock is priced for perfection and had more than doubled last year with investors unconcerned about valuation and lack of profits (expected $180 million of net income on expected $6.8 billion in sales in 2015). The technical set up is poor (yes it is at an important support level, which it has to hold). If investors don’t like what the see, the stock could easily be down inline with the implied move. On a beat and raise, the stock could easily be up 10%, but that is where things get interesting. I suspect any earnings pop higher immediately gets sold in this environment, and the stock finds itself flirting with $100 support again soon.

So what’s the trade?  I think you sell a pop (if it happens as it has the last 7 Q4 reports). I am not inclined to play for the potential pop, but if I were to I would consider doing so with defined risk:

Stock Alternative:  With options prices where they are, and the stock at $106, I would consider a call butterfly, possibly the weekly Jan22 110/120/130 call fly for $2 (buying 1 Jan22 110 call, selling 2 Jan22 120 calls and buying 1 Jan22 130 call). This trade breaks-even at 112 with gains of up to 8 between 112 and 128, with max gain of 8 at 120 and max loss of 2 below 110 and above 130.  This is not a high probability trade, but risks less than 2% to make a wide upside bet into a potentially volatile event and is much better than getting involved in the stock from the long side as far as risk is concerned.

Hedge vs existing long stock position: For those that are long the stock I would look to risk a reasonable amount for unlimited protection. Versus 100 shares of NFLX at 106, The Jan22nd weekly 100/120 collar (buying the 100 put, selling the 120 call) costs 2 dollars. That’s a little less than 2% of the underlying for unlimited protection on your stock. You must be willing to be called away in the stock at 120. That’s a good way to hedge for those with profits in the stock that want to protect those gains and would be willing to sell after more upside on a gap higher.