Netflix Inc. (NFLX) Posts Better-Than-Expected Earnings but at What Cost?

Whether you are an investor, or prospective investor in Netflix Inc. (NASDAQ:NFLX) on the Nasdaq Composite Index, this report will give you some insight into the company. Or maybe you simply like to “Netflix and Chill” and are just curious about the company. Either way, you’ve come to the right place.

Netflix (NFLX) Fundamentals:

The entertainment company, based out of California, U.S.A., released their earnings figures after the bell on Monday.

For the third quarter (Q3) of 2016, net income grew by 75% to $52 million, or earnings per share (EPS) of 12 cent each. That was better than the EPS of 6 cents that had been expected and the 9 cents in the previous quarter.

Revenue climbed 32% to $2.29 billion, which was also higher than the $2.28 billion that had been forecast. But money wasn’t the only thing on investors’ eyes when earnings were reported:

Netflix NFLX - Recap of Earnings Oct 17 2016 - ONE

Many investors consider subscriber growth to be more important than earnings as it provides a key insight into the company’s potential profitability in the future. If Netflix fails to show that they can continue to add new subscribers, both domestically and internationally, then that could spook investors and send them running for the exits.

The good news is that, last quarter, user gains topped analysts’ estimates. Q3 domestic net streaming additions came in at 370K when only 304K had been anticipated. The bad news is that the 3 months ended Sept. 30th were the eighth quarter out of the last ten, in which net new streaming U.S. subscribers were lower than the same quarter a year earlier.

The company finished the quarter with 86.74 million subscribers (above estimates). Of those, 39.25 million subscribers were international.

While the company now sees fourth-quarter domestic net streaming additions at 1.45 million (previously estimated at 1.0 million), that expected jump is still fewer than the 1.6 million added in the U.S. in the final 3 months of 2015.

The company estimates that adding 3.75 million streams internationally is doable for the current quarter. This is important due to the company looking for ways to replace slowing streaming figures domestically. One such place that has massive potential for growth is always China. But there are obstacles there.

Due to China’s regulatory environment being “challenging”, the company is taking a second look at the Asian nation and directing efforts away from it. China, a communist country, is known for blocking western programming and the only way forward for NFLX may be to do a joint venture with a domestic firm in order to get their foot in the door.

In a letter to shareholders, Netflix said: “We now plan to license content to existing online service providers in China rather than operate our own service in China in the near term.”

Netflix NFLX - Recap of Earnings Oct 17 2016 - TWO

While guidance for Q4 (onwards) is optimistic, there is one warning sign that investors should pay attention to and that is free cash burn. NFLX might as well make a bonfire out of cash and videotape it in order to attract more viewers.

Where is all the money going? Netflix is aiming to expand its net streaming services to all corners of the world. It is doing so by creating content and shows that get people hooked. These shows, when exclusively owned by Netflix, give them an advantage when trying to hook viewers and retain them.

The problem is that generating such content isn’t free. The chart (above) shows that it has been a couple years since NFLX last posted positive free cash flow. In the future, the company is obligated to pay $14.4 billion in future payments for streaming video programming. That is almost twice as much as their revenue for the past 12 months.

Burning so much cash is “playing with fire” when the company will need to maintain this kind of burn just to keep existing viewers interested. What if their audience still gets bored despite investing so heavily in new programming?

On the flip side, when the stock rises so much (post-earnings) even when burning so much cash in order to attract more viewers internationally, what happens when they begin to burn less cash in the future? They may be able to find more efficient ways (that cost less) in order to maintain their audience, but who knows if the company will want to take such a risk.

I don’t think that they cut back spending anytime soon because they are aware that technology is changing, let alone competitors, and they will want to fight hand over fist to maintain superiority, while they still have it rather than trying to figure out how to win it back.

I would suggest that the stock could be overpriced, as people continually change mediums on which programs they view. For now, it would take more than 41 days in a row to binge-watch all of the original content (shows and movies) that Netflix will release in 2017.

I should note that during the Great Recession, when many people were losing money, two industries kept thriving: Alcohol sales and movies did well as people kept visiting the cinema in order to temporarily escape their realities and hardships. Netflix has the added bonus of being able to watch from the comfort of your own home but that may not remain a novelty forever.

Netflix (NFLX) Technical Analysis:

Netflix NFLX - Recap of Earnings Oct 17 2016 - THREE

Since the start of the year, Netflix has clearly been the laggard among the four equities dubbed the “FANG Stocks” due to their similarities and industries.

As such, value investors may have been eyeing the company during the past couple months and looking for an excuse to step in rather than holding positions the other tech stocks.

The green arrow (above) represents the size of a possible jump that NFLX would need to see to rejoin either the year-to-date performance of the NASDAQ or its next weakest counterpart.

With the stock having now risen by as much as 20% (to $121.07) in after-hour trading, it seems that this gap has now converged.

Netflix NFLX - Recap of Earnings Oct 17 2016 - FOUR

On the 1-year chart (above) we can see that Netflix has been trapped within a wedge formation (green and red lines).

The stock recently broke out (to the upside) above the red line of resistance but, just as it once did already, that was just a fake-out. In the past couple days, the share price retreated back to within the wedge formation.

While the pink trendlines, based upon the MACD bottoms, suggest that the stock is trading right where it should be, the blue lines, based upon the MACD peaks tell a different story. According to them, the stock should already be trading around $124 per share.

If you look to the background, you will notice that one of the shaded areas, which are rising, are squeezing the price into an even tighter wedge.

Undoubtedly, a massive move was expected after Monday’s earnings announcement. In fact, it is common for the stock to experience at least 3 times the standard deviation post-earnings.

Netflix NFLX - Recap of Earnings Oct 17 2016 - FIVE

The 5-year chart (above) of Netflix gives us a bigger picture analysis of where the stock might go.

Clearly, it is trading within an ascending pitchfork, which is very bullish for the stock. You may notice that I’ve actually included two pitchforks in similar positions as both have meaningful clues (one is shown with dotted lines).

As you can see, NFLX had not yet broken down out of this range. Had it done so, it may have commenced a fall below the horizontal green line of support and possibly even a larger decline down to $40.00.

That is the level where the blue trendlines, based upon the long-term MACD indicate that the true value of the stock is. Unless the MACD begins forming new (higher) peaks I would not eliminate the possibility of us hitting this price in the future. This is despite the fact that I am saying that the stock could lose two-thirds of its value in order to do so.

Prior to Monday’s earnings, the MACD was showing potential of forming a top, while the Relative Strength Index and Stochastics both had negative trajectories, the latter of which had the most room to fall.

Netflix NFLX - Recap of Earnings Oct 17 2016 - SIX

The 3-year chart (above) shows the Fibonacci levels for Netflix stock. These represent significant levels of resistance or support for this particular equity.

You may have also noticed that I’ve added a blue circle to show the corresponding move in the share price after each earnings announcement was reported.

Summary:

While a long-term up-trend continues to remain intact, we are currently dangerously close to the edge of the cliff. That was, until earnings came out. This will buy the stock some time before investors panic and trigger a sell-off.

Eventually, this stock that likes to see wild price fluctuations (in both directions) could even see half of its value erased if panic sets in. There are some technical indicators that still suggest that the stock is overvalued.

For now, the company is seeing good demand, but it could be difficult to maintain that audience even if no new competitors or technologies emerge.

There are rumours of existing users being “un-grandfathered” in order to see price increases but some of those concerns were dispelled on their earnings call.

Those who have been waiting for an excuse to take some profit are presented with an opportunity as the stock soared over 20% after hours Monday. That could help boost markets in general on Tuesday by starting the day off with a good mood. Those traders who are not following their written trading plan to exit at these levels and take profit should be, at the very least, implementing trailing stop-losses after such a big move.

Despite still being among the weaker of the “FANG” stocks in terms of performance this year, Netflix shares are still a little too expensive for my taste. When it comes to high-priced tech stocks, I would have to tip my hat in favour of Alphabet Inc.

This is because Google possess everybody’s secrets including what (and when) they like to search for. This allows them to compile data on every person, tailor custom advertisements to each individual, and maybe even suggest content that they will like to “watch”.

Note: Author currently does not possess any position in any of the stocks mentioned above and has no intention of doing so within the next 3 days.

EconomicCalendar.com provides the latest economic news and financial events that move the market.

About the author

Robert Patyk

Robert Patyk has 15 years’ experience trading stocks, options, commodities, futures options, & currencies. At age 17 he won first place in an international stock trading competition. Robert predicted the market crash of 2008 two years early. He is a contrarian, top-down macro trader achieving high returns by studying geo-politics, fundamentals, and technical indicators.

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