Netflix Inc. Smashes Expectations -- Is It Enough to Support the Stock?

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

U.S. stocks finished the session essentially unchanged on Wednesday, with the S&P 500 up by just 0.06%. The narrower Dow Jones Industrial Average (DJINDICES: ^DJI  ) fell by a quarter of a percent, as the market punished its second-largest weighting, IBM (NYSE: IBM  ) , for its seventh consecutive quarterly revenue decline, pushing it down 3.28%. However, the most heavily anticipated earnings announcement was that of Netflix (NASDAQ: NFLX  ) , which came after the market's close. If the after-hours session is any indication, investors are more than satisfied with the streaming video provider's numbers -- Netflix shares were up 17% just before 7 p.m. ET.

Netflix, which was the best-performing stock in the S&P 500 in 2013, appears to be firing on all cylinders when it comes to the business, too. In the fourth quarter, earnings per share of $0.79 exceeded Wall Street's expectations for $0.66, while revenue of $1.175 billion was in line with analysts' consensus estimate, according to Thomson Reuters I/B/E/S.

More importantly, though, Netflix exceeded its own guidance for contribution margin, achieving 23.4% against 23.2%, thereby exceeding its goal of a four-percentage-point year-on-year improvement on this profitability metric by 20 basis points (one basis point is equal to a hundredth of a percentage point.) Contribution margin is the ratio of the contribution profit to revenue; contribution profit excludes technology and development, and general and administrative costs are accounted.

In its third-quarter earnings announcement, Netflix had also said it expected domestic net subscriber additions of 2 million in the fourth quarter -- the same number as in the year-ago period. Netflix also "beat" on this critical metric with net additions of 2.25 million. That's a good result -- as CEO Reed Hastings and CFO David Wells point out in the investor letter:

Running equal to, or slightly above, prior year net additions is a great outcome because it implies that at 33 million domestic members we're still in the middle section of the S curve of consumer adoption, with years of member growth ahead of us.

That momentum is helpful when you're running on the Wall Street earnings treadmill: Netflix's earnings-per-share forecast for the current quarter of $0.78 is a penny above the current consensus estimate. All told, it's not surprising that investors are cheering the report after hours, but if you assume that the stock was already somewhat overvalued (which I did), what is one to make of this near one-fifth pop in the price?

I can't be the only wondering the same thing. At $390, the price is 10% above the closing level on Oct. 21 -- the date of the last earnings announcement, at which Hastings himself warned investors that Netflix's stock appeared overpriced. Netflix's growth prospects are good and the economics of the business are compelling, but the company remained free cash flow negative in 2013 (although quarterly free cash flow has been positive in the last three quarters). With just $5 million in free cash flow in the fourth quarter, there remains much to be done in order to justify a $20-plus-billion market value. Only investors with a multi-year time horizon and a tolerance for volatility ought to open a position at current prices.

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