Netflix and Gap Fill?

by Dan September 6, 2016 3:34 pm • Trade Ideas

I’ve written about Netflix (NFLX) on a few occasions of late (here, here and here), and while the subscription growth (or lack thereof in Q2) reported in July was disappointing, the M&A environment we find ourselves in makes a property like NFLX pretty interesting, from July 29th:

If MSFT is willing to pay $27 billion for LinkedIn (LKND) because they think they are gonna get massive synergies from their customer data despite running the company as a standalone (I’m VERY skeptical on that), then why the heck wouldn’t Apple, Amazon or Google be willing to pay a 50% premium to NFLX’s $40 billion market cap? The idea here is that one of the aforementioned would immediately leapfrog the others, gain a valuable brand and plug in their 47 million paid U.S. subscribers and 36 million internationally to their existing ecosystems in an effort to create a stronger network effect. With the cash balances where they are with those three ($231 billion, $17 billion & $84 billion respectively), rates where they are, and in the case of AMZN & GOOGL their stocks where they are, the combination of cash, debt and stock as a currency seems to make all the sense in the world for a risky investment, especially if you possess a 50 year time horizon as Cook, Bezos & the Google guys claim to eye.

So this is just pie in the sky sort of stuff, but before its all said and done I suspect we will see at least one blockbuster deal in tech, and NFLX will likely be on the short list. It is that unique of property.

And from August 16th:

Oh and one last thing, over the last week I watched Netflix’s (NFLX) original sci-fi series Stranger Things, which was awesome. After it ended I thought to myself, if this company were use the currency given to them by their own little stock bubble to buy other studios, and create a seasonal schedule like Time Warner’s (TWX) HBO, why couldn’t NFLX be one of the largest media properties in the world given their installed base and first mover advantage?

But then I recalled those pesky fundamentals, like user growth that has decelerated massively, the company in Q2 adding the smallest net subscriber gains since the launch of their streaming service 5 years ago. Also, that Amazon has more U.S. streaming subs than NFLX, that the company has a market cap of $41 billion, or 66% of TWX, a company expected to have 3x NFLX’s $8.7 billion in 2016 sales.

But maybe none of that matters in the environment we are in? Microsoft just paid $27 billion for LinkedIn (LNKD), a money losing (GAAP) company that had $3 billion in sales last year.  Why couldn’t we see a $55 billion deal for NFLX? Trust me, if you’ve been doing this long enough, you’ve seen Stranger Things (AOL/TWX).

I know, I know, this is a stock that I have hated the whole way up and down. So what gives? First things first, I would not buy the stock with your money given those pesky fundamentals like valuation, rising content costs and decelerating subscriber growth. But the stock’s price action, today filling in the Q2 earnings gap and now with the possibility of Q1 (April) gap fill, means it could be poised for a pre Q3 earnings move (estimated Oct 12th).  Today the stock is flirting with its first close above its 200 day moving average since April (yellow below):

NFLX 1yr chart from Bloomberg
NFLX 1yr chart from Bloomberg

So What’s the Trade?  Well there are two that caught our eyes for those looking for a gap fill of the April disaster…

First, defined risk long.

NFLX ($100.20) Buy Sept 30th quarterly 100 / 107 / 114 Call Butterfly for $1.75
  • Buy to open 1 Sept 30th 100 call for $3.05
  • Sell to open 2 Sept 30th 107 calls at 73 cents each or $1.46 total
  • Buy to open 1 Sept 30th 114 call for 16 cents

Break-Even on Sept 30th Expiration:

Profits: between 101.75 and 112.25 of up to 5.25, or 3x the premium at risk. Max gain of 5.25 at 107

Losses: up to 1.75 between 100 and 101.75 & between 112.25 and 114 with max loss of 1.75 below 100 or above 114

Rationale:  this is a way to define you risk to 1.75% of the stock price between now and month/ quarter end. Why did we chose quarter end, well simple, if the Fed does not raise interest rates at their Sept 21st meeting stocks could continue their Q3 party (SPX up 4% and Nasdaq up nearly 9%) and a laggard like NFLX could play a little catch up if we get a mark into quarter end.  Also I see little company specific news between now and Q3 earnings to adversely affect the stock.  Downside to this structure is that an extreme move the upside and you could lose money due to the trade structure.


Or Stock Alternative with no premium outlay:

NFLX ($100) Buy Sept 30th quarterly risk reveral 95 / 105 for even money
  • Sell to open 1 Sept 30th 95 put at $1.01
  • Buy to open 1 Sept 30th 105 call for $1.01

Break-Even on Sept 30th quarterly expiration:

Profits: above 105, but mark to market prior to expiration the position will show gains as the stock rallies closer to the 105 call strike.

Losses: below 95, but mark to market prior to expiration the position will show losses as the stock rallies closer to the 95 put strike.

Neutral: if the stock is between 95 and 105 (highest probability outcome) and there are no gains of losses.

Rationale: as I mentioned above the most probable outcome is that there is no profit or loss on expiration. One would do this trade idea if they were convicted that the stock could have a sharp move higher, but willing to be put the stock down 5% in less than a month if the opposite were the case.  This trade structure has nearly 50 deltas, meaning the position should move in value 50 cents for every dollar the stock moves in either direction. But as time passes both options will lose deltas as the probability that either will be in the money will drop if the stock does not move far from current levels. But above 105 and below 95 it will be like owning stock close to expiration.