Netflix (NFLX) just reported earnings amid some fireworks, including an 800,000-subscriber decline in its domestic business that sparked a steep selloff. NFLX stock suffered a double-digit intraday decline, the worst measure for Netflix shares since 2004.
But as Netflix stock took a big step back, some investors like Carl Icahn managed to dodge a bullet by dumping shares of NFLX at the start of the month. Icahn’s firm bought into Netflix stock early on for an average price of $58 a share, and according to an SEC filing this week booked profits of as much as $800 million as it unloaded 3 million shares.
Netflix earnings certainly rattled some investors, and news that Carl Icahn headed to the exit on NFLX over the last few weeks only increases the cause for concern.
But should you follow Carl Icahn’s lead and sell your Netflix stock, or should you stick with the streaming video giant?
I say sell Netflix.
NFLX Momentum Will End Badly
It’s undeniable that Netflix stock is a story of momentum and sentiment. When you look at a multiyear chart of NFLX, it’s amazing the ground that has been covered — from $50 or so to start 2010, a peak of almost $300 in 2011, a crash to $60 in mid-2012 and a run-up back to $300 this year.
NFLX investors, then, should understand that past volatility is very likely to persist — and that while the late-2011 crash was due in part to a strategic misstep by Netflix and its CEO Reed Hastings attempting to rebrand the DVD arm as Qwikster, there is far more going on here than simply headline-driven moves in the stock.
Furthermore, while short interest has indeed declined from a year ago as the bears have been squeezed out, there are still a number of investors betting against Netflix stock. Consider that at the beginning of October, the short interest as a percentage of the “float” in Netflix stock — that is, shares available for public trading — was over 16%. That’s nothing to sneeze at.
There is always a chance that the sentiment will shift back firmly into the positive and that NFLX will find another leg up. However, given the past volatility in this stock and the recent softness … it’s much more likely that the pendulum is about to swing the other way now that Netflix stock has racked up an amazing 250% gain in 2013 even after the post-earnings selloff.
Long-Term Risks to NFLX Are Valuation and Profits
Beyond the day-to-day volatility that’s driven by sentiment, there are long-term concerns about Netflix to consider.
The biggest chink in the armor is, of course, the fact that substantial growth in NFLX subscribers is already baked into the stock. One analyst at Bernstein recently estimated that NFLX anticipates subscriber growth well above 45 million in domestic subscribers by 2015. Last quarter, the Netflix earnings report showed about 29 million domestic subscribers … so there’s no room for a miss, given the 55% growth necessary in just a few short years.
Hence the recent selloff after a rollback in U.S. subscribers.
And beyond the expectation of subscriber growth, Netflix stock is also trading at a very high earnings multiple on the hopes that big spending on content and international growth will pay off. However, overseas operations are still bleeding cash and the company is seeing margins pinched as the cost of both quality original programming and third-party content from big-name media companies like Disney (DIS) spirals ever higher.
I mean, the forward price-to-earnings ratio is almost 100 … few stocks can get away with maintaining that kind of earnings multiple for long without finally putting up the numbers.
Speaking of stocks that trade for a mammoth earnings multiple, now’s the perfect time to mention that top competitor Amazon (AMZN) continues to make inroads with its own streaming video options provided through Amazon Prime memberships. The heat will certainly be on Netflix in the years thanks to the rise of serious competitors like Hulu Plus, Amazon and even Google (GOOG) as it explores internet television and paid YouTube channels.
Sure, there are hopes that a partnership with cable providers could bring increased penetration for Netflix, with an unholy alliance between NFLX and companies Comcast (CMCSA) and Time Warner Cable (TWC) floated as a way to link the streaming service with the existing telecom infrastructure of cable providers. But that won’t pay off anytime soon, if it even gets off the ground — and could risk tying Netflix stock to old-school cable companies, which aren’t exactly a roaring growth business.
The bottom line is that when you add up the risk of fading sentiment and the extreme valuation based on long-term challenges … it doesn’t seem wise to invest in Netflix right now.
Prudent investors will sell at least some of their NFLX shares to protect their profits. And unless you are ready to take the tiger by the tail, steer clear of Netflix stock until the dust settles — because it could be a bumpy ride for a few months after this earnings miss and the high-profile exit of Carl Icahn.
Related Reading on NFLX
- Told you so – why I predicted trouble for Netflix earnings. (The Slant)
- On the Carl Icahn sale of Netflix stock. (Reuters)
- The NFLX earnings details. (Bloomberg)
- Check out Netflix short interest trends over time. (Nasdaq)
- On the slow but inevitable decline of the Netflix DVD business. (GigaOM)
Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks. Write him at firstname.lastname@example.org or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.