Netflix's Rebound…Mission: Impossible?

Netflix’s Rebound…Mission: Impossible?

Is Netflix (NFLX) making a comeback? Or as they say in the movie biz, will it be a blockbuster?

(Hopefully, it’ll never meet the same fate as the real “Blockbuster”—the video rental chain that Netflix buried with its video-by-mail and video-on-demand content businesses…)

Netflix’s stock is up more than 23% today on its latest earnings report, so clearly, the hate that drove the stock down 60% in 2011 may have gone too far. Analyzing the prospects of former high-flyers is never easy—this one especially so.

I have a strong opinion on Netflix, in large part because it was one of our big winners in 2010. We captured a big chunk of its hypergrowth phase, riding the stock up from $111 at the end of May 2010 to $235 by late April 2011.

That’s when we took our money off the table. We missed out on the final spike up to $300, but I don’t mind one bit. We got out on the way up, just as the great growth stock’s fundamentals started to deteriorate, with a fine 112% profit.

So is there another 112% profit to come in the stock? I’ll answer that question by sharing what we learned about Netflix the first time around, and also tell you whether you should be a buyer or a seller of Netflix today.

The full story is here.

The Sixth Sense

Now, I don’t want to pat myself on the back too much. Although it may have seemed tough to go against the grain and sell Netflix when it was on a tear, my strategy of looking at the numbers, and not the “story” of a great stock, made it an easy call.

Not that I didn’t get a few angry letters from subscribers who thought I sold Netflix too soon. We do sometimes get out early on a good stock, but I hope my readers who stayed in Netflix got out before the -77% collapse from it’s peak price!

Here’s what I told my subscribers last April:

Netflix has been one of our highflyers over the past several months, gaining more than 100% since I first recommended it last June. The stock has constantly stolen the headlines with its good results and positive momentum, but it seems that the party might be coming to an end for this stock.

Netflix posted a profit of $60.2 million, or $1.11 per share, for the quarter ended Mar. 31. This beat analysts’ estimate of $1.07 per share and trounced last year’s first-quarter result of $32.3 million, or $0.59 per share. Revenue also surged, by 46% to $718.6 million.

The reason shares dropped in yesterday’s trading was the lower-than-expected second-quarter guidance. The company said it expected a profit of $0.93 to $1.15 per share, lower than analysts’ forecast of $1.19 per share. The reason the company gave for the disappointing forecast was an increase in spending on the movie licenses the company needs to distribute content. The company is obviously spending its money wisely, investing it in library upgrades, but this is coming at the expense of the company’s bottom line.

I would like you to sell out of your shares of NFLX and cash our 112% gain.

Transformer…or Titanic?

Netflix is a great illustration of how my system separates the wheat from the chaff.

Almost every company is run by smart people working very hard to grow their business, but sometimes hurdles are too high for even the brightest managers.

In Netflix’s case, simultaneously growing the business and making the transition away from the video-by-mail segment not only angered subscribers, it also entailed new investments in exclusive content and advanced delivery systems.

These big investments may be the spark Netflix needs to drive its next big growth wave, but for now, they are causing two very big problems.

First, the investments sucked up lots of cash that led to a drastic change in Netflix’s fundamentals. Those changes were the first warning signal that all was not well with this great company.

Second, the uncertainty of a confused corporate strategy caused lots of investors to rethink their Netflix stakes, and the resulting lack of buying pressure is what really hammered the stock.

Without a steady supply of new money and new investors excited about a company’s prospects, the stock didn’t just stop rising, it cratered.

The combination of two bad signals—fundamental data and quantitative buying pressure–told me it was time to step aside from Netflix.

Netflix’s Reed Hastings made a lot of skeptics look foolish on the way, up, and a lot of fans equally foolish on the way down.

He may be able to keep Netflix moving in the right direction, but I’ll need to see a lot more evidence that his strategy is working before I’m ready to call this stock a buy again.

And that’s the $64,000 question: Do the latest earnings signal that it’s time to buy another ticket to the Netflix show?

The Good, The Bad and The Ugly

So what are the numbers telling us about Netflix today?

Despite encouraging news that customers are coming back to Netflix—610,000 new U.S. subscribers reversed an ugly exodus of customers upset by new pricing plans and less flexible subscriptions—there are still troubling signs that there is a lot more hard work to be done.

Revenues rose 47%, but the profit picture is still a big problem. Profits slid 13% on the capital spending mentioned above, plus new marketing and infrastructure expenses for international expansion.
Those efforts are bearing fruit (Netflix added 380,000 international subscribers in the fourth quarter), but not without heavy costs. Netflix estimated its international operations would unprofitable for the whole year as a result.

More bad news: Netflix’s video library will shrink when its content deal with pay-TV channel Starz ends in February, including 15 high-demand Disney movies. Factor in competition from Amazon Plus and Hulu plus big expenditures to license exclusive content from DreamWorks and new episodes of “Arrested Development,” and there’s just too much uncertainty for the Netflix party to get restarted any time soon.

I’ll be happy to take another swing at Netflix if the picture improves, the growth initiatives work, and the company’s fundamentals rebound.
But for now, I’m steering clear.

The Secret of My Success

As always, the best way to check out any stock—already in your portfolio or on your watch list–is through Portfolio Grader.

Today, Portfolio Grader rates Netflix as a “D,” for all the reasons I listed above.

Portfolio Grader alerted us early on to the troubles at Netflix, and got us out with a hefty profit, before the bottom dropped out.

It can do the same for you–alert you to stocks about to nose-dive, and pinpoint stocks on the way up.

Try it for yourself.

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