Netflix Dropping Like a Ton of Bricks

by John Jagerson and Wade Hansen | September 13, 2012 1:35 pm

Netflix‘s (NASDAQ:NFLX[1]) fall from grace is well-known[2]. After notching an all-time high just shy of $300 per share in July 2011, it proceeded to lose more than 78% of its value before mounting any rally. But after bouncing back up into the $120s, it has resumed a heart-wrenching decline for committed investors.

While the market has been moving higher in starts and stops, NFLX has been languishing. While competitor Amazon (NASDAQ:AMZN[3]) is again approaching its 52-week highs, Netflix is down more than 20% YTD.

NFLX 300x178 Netflix Dropping Like a Ton of Bricks
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In the accompanying chart, you also can see a technical pattern that has been repeating in NFLX during the last several months. A gap lower leads to some short-term buying (often referred to as a “dead cat bounce” by traders), which then results in new selling below prior lows. We expect that to play out again in September through October this year, as well.

Trading High Margins for Growth

At stake is what kind of business model Netflix is going to pursue — and possibly even deeper than this, what kind of company it wants to be.

Whereas NFLX made its name as a DVD rental company, it has been remaking itself into an online streaming company. While this certainly is a necessary strategic move as physical DVDs move toward obsolescence, it also is a decision that shifts the core business from a high-margin operation to a business model with much lower profitability and significantly fiercer competition.

Just how much of a profitability difference exists between the DVD business and the streaming business? During Q2 2012, NFLX saw revenues of $291 million from its DVD rentals with a profit margin of a remarkable 46%. Its worldwide streaming business, on the other hand, grossed $598 million yet brought in a net loss of $6 million.

Part of this net loss comes from NFLX’s dedication on growing its streaming business into various markets across the world. Netflix is currently available in Canada, Latin America, the U.K. and Ireland with plans to expand into Sweden, Norway, Finland and Denmark this year. While these expansion plans have been very costly (overseas streaming resulted in a $89 million loss for the quarter), they eventually will begin to contribute positively to NFLX’s bottom line as these markets mature.

But the margin issue remains a big question. It is unlikely that the streaming operations will come close to matching the margins contributed by NFLX’s DVD business. And even if DVDs are a dated technology, the rush to replace high margins with very low ones has investors wondering.

From Content Provider to Content Producer

These compressing forces so worrying to investors are not lost on NFLX management — although some have wondered. With falling margins, rising content costs and knowing how well (ahem) previous rate hikes have gone over with Netflix subscribers in the past[4], the company has tipped its hat that it might use its own original programming as another strategy to gain and keep customers — perhaps, even, with a premium.

Starting as an outlet showcasing movies to becoming a creator of critically acclaimed original programming in its own right is something that HBO and AMC, for example, have done extraordinarily well. Noticing the success, other channels have followed suit. And with content providers encroaching on NFLX’s territory by starting their own subscription services available anywhere, NFLX is about to return the favor and enter the content game.

However, if NFLX’s slate of programs doesn’t wow initial audiences, the company could not only be looking at increasing content costs to keep its library of movies compelling to subscribers, but could be feeling the additional blight of being seen as uninteresting. It’s not likely subscribers will give them multiple chances to incubate successful programming if the first attempts are vapid and dull, especially if they need to hike monthly rates in the meantime.

Even with good shows, this will be a strategy that takes time to translate into higher rates and higher margins as it requires building a brand. It might take several TV seasons before NFLX positions itself as a legitimate player in the original programming field, which provides a window to short the stock and play bearish puts.

We recommend a short position on a break below support at $54 per share. Alternatively, we recommend the NFLX Dec 55 Puts at $6.75 or less to take advantage of the potential for a decline.

John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader[5], a trading service designed to help you make options profits by trading the news.

Endnotes:
  1. NFLX: http://studio-5.financialcontent.com/investplace/quote?Symbol=NFLX
  2. well-known: http://investorplace.com/2012/07/netflix-to-short-or-not-to-short/
  3. AMZN: http://studio-5.financialcontent.com/investplace/quote?Symbol=AMZN
  4. have gone over with Netflix subscribers in the past: http://investorplace.com/2011/10/netflix-stock-nflx-qwikster-subscribers/
  5. SlingShot Trader: http://slingshot-trader.investorplace.com/

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