Netflix (NFLX) Q3 Earnings Preview – Stranger Things Have Happened

Price Action / Technicals: NFLX is down 13.5%% on the year, trading nearly to the dime where it was trading prior to its Q2 results on July 18th.  Importantly, the stock is up 17% from its opening lows on July 19th, which was in fact the low between now and then.

The chart since the start of 2015 has a couple very definable qualities, first formidable technical support from $85 to $80, and the stock’s recent resilience over the last couple months forming a base just below $100 but importantly above the downtrend that had been in place from the all time highs made in early December at $133:

[caption id="attachment_67171" align="aligncenter" width="600"] NFLX since Jan 2015 from Bloomberg[/caption]

Expectations: Yesterday the WSJ’s Steven Russolillo had a fairly cautious take on NFLX’s future giving growing competition; Netflix Isn’t Headed Toward a Happy Ending

After launching in over 130 countries in January, Netflix’s global expansion has yielded lumpy results. Perhaps more importantly, its U.S. subscriber growth has disappointed recently. During the second quarter, Netflix added a surprisingly low 160,000 net domestic subscribers, well below its prior forecast of 500,000. It estimates 300,000 net U.S. subscriber additions in the third quarter.

With 47.1 million overall U.S. subscribers, Netflix remains far from its long-term goal of 60 million to 90 million. Some analysts believe that target might no longer be achievable, particularly as prices rise and competition picks up from Amazon.com Inc., Hulu and others. In July, Mr. Hastings said price increases for existing subscribers led to higher service cancellations.

Competition has yet to be pinpointed for declining subscribers, as the company the last couple quarter has led investors to believe it has more to do with price increases, leading to major shortfalls both here and abroad, per WSJ, for Q2:

net subscriber additions for the second quarter fell short of its forecast both domestically and internationally. It added a net 160,000 U.S. subscribers, a far cry from the 500,000 it predicted. Outside the U.S., Netflix added 1.52 million new subscribers versus the 2 million it was expecting.

There is little doubt that the sharp drop in net adds is a combination of both pricing pressure and rising competition, but I want to reiterate the potential stickiness of original content, which surprises like this Summer’s smash hit Stranger Things might cause a rush for new or old subs. From Aug 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).

So what’s the trade?

I have no idea whether the company bucks the last two quarters negative trends. If it does it will likely due to re-acceleration in sub growth on the back of Stranger Things, and the stock will very likely be up at least in line with the implied move of 10%. On the flip-side, the third consecutive disappointment and the stock is back in the mid $80s.  All that said, I suspect the company quickly becomes take-over fodder with a $35 billion market cap.  Linkedin (LNKD) was taken out at nearly 7x 2016 sales of $3.8 billion, despite a GAAP net income loss of an expected $182 million. NFLX is expected to have $8.7 billion in sales, trades a little less than 5x and is expected to have GAAP net income of $118 million in 2016.  I guess I can say I’ve seen Stranger Things.

For those that are long the stock and looking to super charge a move to the upside, the weekly (Oct 21st) options provide a bit of an opportunity to do that.

Leverage:

vs 100 shares of NFLX ($99.50) buy the Oct21st 110/115 1×2 call spread for a 5c credit:

• Buy 1 Oct21st 110 call for 1.75
• Sell 2 Oct21st 115 calls at .90 (1.80 total)

Rationale – If NFLX outperforms the implied move to the upside this trade has the potential to add up to $5 in additional gains above 110. If the the stock declines or is simply up but not above 110 it is nothing done and the small credit is like a free look. If the stock squeezes substantially and is above the short strike profits are capped and you can be called away in the stock, but at an effective price of 120, or 20% higher. Not bad.

What about those that are long the stock and looking for protection? To protect against disaster (a move to 80) you can sell an upside call above the implied move to finance a put spread that captures the next $10 below the implied move on the downside.

OR

Disaster Protection:

vs 100 shares of NFLX ($99.50) Buy the Oct21st 112 – 90 collar for even money

• Sell 1 Oct21st 112 call for 1.45
• Buy 1 Oct21st 90 put for 1.45

Rationale –  The 112 call sale should be high enough and outside the implied move that it likely doesn’t come into play, but if it does its being called away in the stock on a 12% move higher, so this is for people fine with those type of overnight profits on their stock. On the downside, if this was the quarter where investors finally give up, you will  be well protected below the implied move.