Netflix: Three Strikes and You’re Out!

December 14, 2010
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All good things must come to an end…

That’s especially true for “hyper growth” stocks like Netflix Inc. (NFLX) which has given bullish traders quite a return this year.  From its closing price of $55.09 on December 31, 2009, the stock has rallied as much as 280%, topping out above $200 on December 1st.

To the casual observer, Netflix is still a great growth story.  For the third quarter, the company announced 31% growth in revenues, 42% growth in earnings per share, and a 52% year-over-year increase in subscribers.  But with so many investors and traders already firmly settled on the bandwagon, NFLX has been bid to a price where perfection is not only expected…  it is demanded!

Over just the last few weeks, the bullish picture for NFLX has taken on water – both from a fundamental business standpoint as well as from a technical trading perspective.

Essentially, this is a “three strikes and you’re OUT” situation – and we’re playing the short side as the momentum crumbles.

Strike One: Turbulence at Home

Most good growth companies bear a resemblance to a large family.  The executive team shares a common vision which is constantly communicated to employees, vendors, customers and investors.  In order for strong growth to continue, all four of these parties must be fully on board and committed to the mission.

For Netflix, this previously cohesive family is beginning to unravel.  Of course every family has its rivalries and tough days, but in this case, the disagreements are leading to true dysfunction – and threaten to significantly affect the company’s operations in the coming months.

On December 7th, Netflix announced that CFO Barry McCarthy would step down and be replaced.  Of course the announcement was well phrased, offering both an optimistic view of the new CFO, and throwing a few kind words towards the departing executive.

We are lucky to have an executive with David’s proven financial skill and operating impact within the company and I am confident he will continue to serve Netflix extremely well as CFO…

At the same time, we offer both great gratitude and sincere best wishes to Barry.  Over the last few years, Barry has balanced his affection for Netflix – and the excitement all of us have felt by the tremendous growth of the company – with his personal desire for broader professional opportunities.  Barry concluded that now is the right time to seek out those opportunities, and we will be cheering for him.

Considering the fact that McCarthy is leaving one of the top growth companies in the US right now, one has to wonder what opportunities could possibly exceed his current role.

At the same time that McCarthy is making his exit, the company’s vendors are becoming increasingly discontent with the current arrangement.  Media companies who license their content to NFLX for distribution are realizing that Netflix is becoming the medium of choice for watching this content – a medium that offers the vendors very little in terms of profitability.

Next year, a key deal between NFLX and Starz will expire – and with it, Netflix’ ability to stream Sony and Disney content.  In order to renew this contract, NFLX will likely have to pay up – and many question whether the economics work when NFLX is only charging customers $8 to $10 per monthly subscription.

Ironically, Netflix’ success has developed into its greatest liability.  Media content producers feel that if they license their movies or television shows to NFLX, they are then unable to profitably sell this same content through any other medium.  So with these vendors feeling increasingly threatened by Netflix’ success, the profitable business model may in fact be reaching the upper-ends of feasibility.


Strike Two: Major Price Failure

There’s nothing magical about large round numbers.  When it comes to fundamental valuation, $147.38 can be just as meaningful ad $300.00.  But from a trading perspective, large round numbers often come into play as significant milestones – especially when it comes to momentum stocks.

For Netflix, the $200 level appears to be one of those key inflection points.

On November 30, after the black Friday Thanksgiving weekend, NFLX broke through and closed above the $200 barrier on volume nearly twice its average level.  To any self-respecting short trader, this was definitely the time to get out.  In fact, short covering likely played a significant role in pushing the stock through this level in robust trade.

But on Tuesday, it was a bit curious to see NFLX trade back below this key area  with volume still well above average.  From a technical perspective, this was as close to “ringing a bell” as you can get.  The next day, NFLX gapped lower and we began plotting our strategy for building short exposure.

Strike Three: Index Effect

The final nail in the coffin came as a complete surprise to many.  Last week, both the S&P 500 and NDX 100 indices announced that they would add NFLX to their roster.  While the announcement means absolutely nothing to the business metrics for the company, this type of announcement usually kicks off significant buying as passive index managers add the stock to their funds.

The announcement hit the wires after the close on December 9th.  Immediately, NFLX was back above the $200 mark in off-exchange trading.  But by the time the market opened on the 10th, the excitement had cooled and the positive gap was much smaller. The stock weakened throughout the day and by 4:00 EST, the majority of the “index effect” had worn off.

Monday morning, NFLX opened weaker – and slid throughout the day.  The positive effect from the index addition has now completely evaporated – a testament to the stock’s capitulation.

Mercenary Trader is now holding significant short exposure in this breakdown play – having taken a full short position when the $200 inflection point failed, and added pyramid exposure when the index effect failed, we are now sufficiently “beared up” and set to benefit from a sharp drop.  (All setups and trades will be available to members of the Mercenary Live Feed)

At this point it’s difficult to determine who would step in and support the stock.  Momentum traders are likely to shy away because the trend is at best in danger – and at worst completely broken (depending on what time frame you look at).  True investors will likely avoid the stock because of the premium multiple and the fundamental challenges.

Index investors represent one potential buying group, but most managers are already building their positions and we aren’t seeing any significant strength from these buy tickets.

Of course our risk point is in place and trading is always a game of probabilities.  But at this point, the probabilities are heavily skewed to the bearish side, and we’re set to capture profits along the way.


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