Observations About an Extraordinary Day

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By Newsman
July 20, 2004

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It's been a wild day. Let's talk for a few minutes.

1) Look at that share volume today: 26 million shares. That is a more incredible fact to me than the price drop. That is well over 10 times the daily average, well over half the public float, and theoretically plenty of volume to cover the entire outstanding short interest. I wonder how much of that was new short positions being taken, how much old ones being covered, mutual funds dumping, mutual funds buying, etc. I have no way to tell, of course (and this month's short interest numbers won't tell us, because they'll reflect yesterday's short count). But I suspect the short position didn't decrease very much. There seemed to be a lot of piling on. We'll know in about six weeks.

2) Isn't it weird that somehow the market decided that an 8-9 dollar decline was about the right haircut to give? It didn't jump around during the day, just dropped, then slid a little for the remainder of the day. I would love to hear someone's argument for why that's a rational (rather than arbitrary) amount for the stock to drop after this report. Clearly, it's not based on a DCF analysis, (or else the street isn't buying the guidance) because they actually slightly raised future guidance. It all feels pretty knee-jerk and emotional to me.

3) All that said, this feels like a Wall Street spanking. The analysts on the call were not happy about little things like them spending money to relocate distribution centers, when they hadn't baked that spending into their guidance. It's a valid point, but you can't anticipate everything, and maybe they saved a little cash or improved service by being able to make those changes. I think it's an apt criticism as well that Netflix' guidance ranges are ridiculously wide. They always seem to hit or exceed the top end of them (this quarter included, actually), and I don't see why they think it will cushion the disappointment for anyone if they hit within their range, but at the low end. Look how disappointed the street was with hitting above the midpoint! The top end of the guidance is the number that the street is fixating on. Throw away the bottom half of the range; no one is paying attention and it just makes you look like you have no idea what will happen. For Wall Street's part, it needs to have more realistic expectations. And Netflix managers have to realize that they have to conduct business differently now as a public company than they did as a V.C. funded startup. I bet they are stunned with this reaction to their call yesterday.

4) I observe a paradox: It would be in the best immediate interest of management to spend less on marketing, blow the profit number out of the water every quarter, squeeze the shorts and pump up the stock price in the short term so they can sell some shares. Under that scenario, they wouldn't invest in a UK expansion, which will take a bite out of the profit number for the foreseeable future. Instead, they truly seem to be willing to take it on the chin in the short term because they believe that's the best business strategy over the long term. This either means they have no idea how to play the game, or that they are people of integrity and vision who really believe that this is a business that's going to be much larger in 10 years than it is now. I suspect it's the second, and I hope they are right. But they should have known when they reported their first profit that Wall Street would expect it to grow in a more or less linear fashion, and they should have figured out how to make that happen. Here's a company that's already had shareholders authorize additional shares for another split but that isn't going to need the capacity unless they can keep their investors happier.

5) If Netflix, with all its scale and so much of its distribution infrastructure already paid for, has to charge $22 a month to make money renting movies online, why does anyone think that Blockbuster can make money at 19.99? They essentially have to set this up as a parallel business that competes with their main business. I like their strategy to move toward games and buying/selling used DVDs much better than online.

6) Forward P/E is 16. Company is growing at 90 to 100 percent [year over year] in terms of revenue. If they meet 05 analyst estimates, their earnings will grow 300 percent next year. If they miss by 20 percent, earnings will still double, and the P/E will still be about 25.


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