Shares of Netflix (NASDAQ:NFLX), which came into Monday’s earnings number trading at 42 times 2012 profit estimates, were blasted after the company lowered its third-quarter revenue projection to a range of $780 million to $805 million — well short of analysts’ $845 million target. Among the reasons Netflix cited for the cut was customers’ dissatisfaction with its 60% price hike for subscribers who bundle the streaming and DVD delivery services. Although CEO Reed Hastings said “We are feeling good about the decision” on the post-earnings conference call, it appears the market doesn’t fully agree.
It isn’t particularly surprising that bad news would cut such a large chunk off of the market cap of a stock so richly valued. Now, the challenge for investors is to determine the appropriate valuation for Netflix. Paying 42 times for a stock that had been growing at 50% annually is one thing. But with rising competition, higher costs and the company’s rapid-growth phase now seemingly just a memory, how much is Netflix actually worth?
Realistically, the longer-term answer is that Netflix should probably trade quite a bit below $255.50, where its shares opened Tuesday morning. The stock has been, and remains, overvalued for a company with rising costs, increasing competition and a business with low barriers to entry. Netflix seems destined for a path similar to that of eBay (NASDAQ:EBAY), where the stock is flat to down over a period of years as the P/E ratio deflates. As a result, a long-term investment in Netflix seems unadvisable now more than ever.
The short-term outlook also is problematic. The initial plunge on Monday’s news shatters a long-standing, upward-sloping trendline that has been in place for more than a year now, and the 200-day moving average — at just below 218 at Monday’s close — is nowhere in sight. With the stock’s valuation still rich and the market showing a pronounced tendency to punish stocks that fail to meet expectations, it appears Netflix has some room to run on the downside.
But — and this is an important “but” — this doesn’t mean that it’s time to write off the stock entirely. In fact, Netflix is likely to be fertile ground for traders to make money during the second half of the year. For those willing to buck the negative sentiment, there are two factors that should provide plenty of opportunities on the long side.
First is the short interest, which stood at 20% of the float as of June 30. Although the majority of short-sellers still are likely to find themselves underwater even with the stock well off of its high of $305, this massive short interest provides the fuel for explosive counter-trend rallies.
Second is the renewed potential for the company to deliver an upside surprise later this year. Despite the negative coverage, one quarter of lowered guidance does not necessarily signal that Netflix has stopped growing. Revenues remain on track to cross the billion-dollar mark in the fourth quarter, which could enable the company to exceed full-year earnings estimates. What’s more, the fact the price hike won’t go into effect until Sept. 1 means third-quarter numbers will reflect all of the fallout, but little of the top-line benefit, of the controversial move. While this doesn’t alter the valuation problem, it does set the stage for a positive surprise relative to sharply lowered expectations.
The bottom line: The idea of even thinking about a long position in Netflix seems dicey, at best. Nevertheless, the idea that the Netflix story is over offers contrarian-minded traders the chance to ring up some short-term profits in the months ahead — rich valuation or otherwise.
Daniel Putnam does not own shares of any of the aforementioned stocks.
