Is Netflix Overdue For Another Correction?

When Netflix (NASDAQ: NFLX  ) reported third-quarter earnings on Oct. 21, the stellar results came with a grim warning straight from the executive suite.

"In calendar year 2003 we were the highest performing stock on Nasdaq. We had solid results compounded by momentum-investor-fueled euphoria. Some of the euphoria today feels like 2003," said the CEO and CFO's joint letter to investors. "Despite the huge swings in our stock price since our 2002 IPO ($8 to $3 to $39 to $8 to $300 to $55 to $330), we've continued to grow our membership every year fairly steadily. We do our best to ignore the volatility in our stock."

CEO Reed Hastings added to the somber note in the conference call, "We have a sense of momentum investors driving the stock price more than we might normally. There's not a lot we can do about it but I wanted to honestly reflect upon that."

Investors took Hastings' word to heart for a while. Netflix shares briefly spiked nearly 10% higher the next morning because the subscriber counts came in strong, but then sunk 9.4% below the previous closing price before the next bell tolled.

"We got the memo, Reed!" Netflix investors seemed to be saying. "Don't worry, this is not another momentum bubble!"

And then they forgot all about it. Here's what Netflix shares have done since the temporary low on Oct.22:

NFLX Chart

NFLX data by YCharts

Yeah, so Netflix shares are once again trading above the $355 level that had made Reed Hastings so mellow just a few weeks ago. Lesson not learned, obviously.

Is this 12.5% climb natural or unreasonable? Are Netflix shareholders (yours truly included) setting ourselves up for another dramatic correction somewhere down the road?

What's going on?
Well, Netflix shares do have a tendency to pop sky-high on fourth-quarter reports. The company likes to grow over the holidays, powered by electronics under the tree plus cold winter nights with nothing better to do than watching TV. The climbing share prices just might be Mr. Market's collective attempt to head off the expected overnight shock we've seen in years past.

Would you buy a media subscription service from this man, Netflix CEO Reed Hastings? Would you listen when he tells you to lay off momentum investing in his stock? Image source: Netflix press room.

It's also true that investors are buying Netflix without much of a rudder these days. The company has decided to sacrifice earnings and cash flows in the short term, in exchange for faster international expansion and higher-quality domestic content. P/E ratios and cash flow-based valuations are off the charts, and there's no reasonable way to put an honest value on Netflix today -- at least not based on traditional valuation tools.

This will not change anytime soon. Even if Netflix briefly turns a solid profit in 2014 (which may or may not happen), the Walt Disney (NYSE: DIS  ) first-run deal kicks in for 2015. Expect Netflix to milk its exclusive premium cable window for one of the major studios by growing and promoting its streaming services as hard as possible in 2015. Disney would certainly expect nothing less from its handpicked distribution partner.

So that value investor toolbelt will remain useless for several years. Left without their favorite valuation tools, many Netflix investors are simply guesstimating their Netflix valuations for the time being.

There has to be another way
Or, you can look beyond the lean years and project Netflix's earnings power when international markets start to mature, and the Disney deal honeymoon starts to fade. On that basis, I expect Netflix shares to hit at least $600 sometime in 2016. Anything less would mean that I underestimated the competition, overestimated the overseas opportunity, or both.

Like Reed Hastings, I'm not terribly worried about what Netflix's stock does in the meantime. If it falls again, I might buy more; If it spikes to entirely unreasonable levels, I might take some profits on my largest personal holding.

But I intend to own most or all of my Netflix stake for the next three years, and probably far beyond that. Volatility doesn't bother me. Netflix shares may indeed be due for another correction, but next summer looks more likely than the traditionally explosive holiday quarter.

All that remains is keeping an eye out for game-changing mistakes in the Qwikster vein, or else get ready to reap the long-term rewards of owning a global media giant in its formative years. Oh, and keep some dry powder on hand in case investors panic over another non-event. The buy-in window might not stay open very long, if the last couple of months taught me anything.

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  • Report this Comment On December 11, 2013, at 11:39 AM, singingTRUE wrote:

    In the dot com era of the late 1990s, we saw stocks trading at over 100 price per earnings, which was deemed high then. That bubble saw a significant correction. Now, we see what seems to be a new definition of high P/Es with stocks like Netflix and Amazon. How are these justified?

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