Back to top

Image: Bigstock

Netflix rallies, Why?

Read MoreHide Full Article


After rising more than 100% in 2018, Netflix (NFLX - Free Report) hit a snag on Monday after reporting sales and earnings that were basically in line with analyst estimates, but disappointing figures for subscriber growth.


Read about the expectations and the miss here>>


Investors punished the stock, sending it down over 13% in after-hours trading to a low of $347/share.


It’s a different story on Tuesday however, with shares regaining a big chunk of yesterday’s losses, trading at $379/share at mid-day - down about 5% from Monday’s close.


Why?


It’s an interesting story, about both Netflix itself and also how the markets digest earnings announcements, especially on difficult to value growth stocks.


At $400/share, Netflix was trading at a 12-month forward P/E ratio of 140X. For comparison purposes, the S&P 500 trades at a forward P/E ratio of 18X, Goldman Sachs (GS - Free Report) at 10X, and Micron Technology (MU - Free Report) at just 5X.


Fundamentally, investors pay for future cash flows.


There are plenty of mature companies that are leaders in their industries, enjoy significant market share, operate on a positive cash flow basis and return that cash to investors in the form of a predictable dividend. Their prospects for growth are minimal – they’ve already spread out about as much as they can – but they’re not going anywhere either, and the income they provide is valuable. These stock are easy to value, if fact they're more like bonds, priced at the sum of the present value of the future cash flows.


At the other end of the spectrum is a company that is actively growing as much as possible. The company has no intention of returning any cash to investors any time soon.  In fact, like Netflix, they probably not only spend every dollar they take in, but borrow money as well, finding that the return on every dollar they spend exceeds the borrowing costs.


Investors own stocks like this for the future, and the prospect that someday the company will have succeeded in their mission to saturate a market, at which point they will slow spending on marketing, hiring, infrastructure expansion and everything else and net earnings will skyrocket as they enjoy stable revenue and shrinking costs. They will have essentially "grown into" their share price as the higher earnings imply a more standard valuation.


Netflix is unlikely to significantly beat or disappoint estimates for sales and earnings because their business is mathematically very simple. We know how many subscribers they have and we can multiply by the average price those subscribers pay (about $10/month) and get a solid estimate for sales. They tell us ahead of time what they expect to spend on content – by far the biggest component of expenses – so analysts just add back reasonable estimates for marketing, technology and administrative expense and it’s hard not to be in the ballpark on net earnings.


If you look at their recent history, you’ll notice the earnings have been very predictable:



That’s why everyone is so focused on the subscriber additions number. It has become the barometer for whether the Netflix is still in that rapid growth stage - in which the price multiple to earnings is not all that significant – or whether they’re getting close to the day that the music stops and they become just a regular company that provides a service that the market demands and makes money year-in and year-out, but deserves to be valued like a mature company.


Unfortunately, Netfilx is simply not very accurate at estimating how many subscribers they are going to add in any given quarter. So far in 2018, they have added 12.5 million subscribers – 7.4M in Q1 and 5.1M in Q2 - and having estimated 6 million additions in each quarter, they surprised the markets once and disappointed once. In Q1 it was seen as great news and in Q2 it was seen as bad news, even though the overall growth story was little changed.


NFLX’s forecast for subscriber additions in Q3 is 5 million. Based on recent results, it wouldn’t be all that surprising if they beat or miss by 20%. Unless subscriber growth trends in one direction for several quarters in a row, it’s probably not cause for either celebration or concern.


The takeaway here is that the markets tend to get nervous about the high-flyers with big valuations and grasp at some other metric that describes the company’s long-term prospects and/or gives an indication of where the company is in the growth cycle. Once the entire report has effectively been reduced to a single number, big price swings tend to happen as traders race to discern that number and buy or sell shares for quick profits.


Once cooler heads prevail and digest the entire report – often including a conference call that might not happen for several hours after the initial release – the price often moves to a more reasonable level. This appears to be what’s happening in Netflix.


Today's Stocks from Zacks' Hottest Strategies It's hard to believe, even for us at Zacks. But while the market gained +21.9% in 2017, our top stock-picking screens have returned +115.0%, +109.3%, +104.9%, +98.6%, and +67.1%. And this outperformance has not just been a recent phenomenon. Over the years it has been remarkably consistent. From 2000 - 2017, the composite yearly average gain for these strategies has beaten the market more than 19X over. Maybe even more remarkable is the fact that we're willing to share their latest stocks with you without cost or obligation. See Them Free>>


See More Zacks Research for These Tickers


Normally $25 each - click below to receive one report FREE:


The Goldman Sachs Group, Inc. (GS) - free report >>

Netflix, Inc. (NFLX) - free report >>

Micron Technology, Inc. (MU) - free report >>