Netflix and the Market

On October 15th, Netflix’s stock price crashed – dropping more than a $100 – on news that the company had not reached its forecast target for new subscribers.

They fell short of a predicted 3.7 million new members, adding 3 million between July and September. The previous quarter, April to June, showed growth of about 1.7 million members.

So what’s the big deal? 3 million new members may have missed the mark of 3.7 million but on a quarter-to-quarter basis it’s still very strong!

Going back further, on a yearly basis, Netflix grew their subscriber base by 7 million in the first 9 months of 2013. For the same period of time in 2014, they’ve added 9 million. That’s good news!

So why did Netflix lose about 25% of their market value?

Netflix is a funny little company in that they are heavily reliant on the online streaming component of their business. They really only have two streams of revenue: online streaming and DVD rentals.

And DVD rental revenue and subscriptions have been steadily declining since 2011.

Bottom line: All the growth in the business has to come from one source: online subscriptions.

That’s why there’s so much importance placed on that number! It didn’t matter that they reported a Q3 (third quarter) profit of nearly $60 million, up from $32 million a year ago; Netflix shares still tanked!

And boy was there was a lot of speculation as to why…

HBO announced their online streaming service; they’re going to be direct competition for Netflix!”

“The price hike was the reason as to why Netflix missed the mark on new subscribers”

 

While it’s true that HBO announced a new streaming service, that doesn’t mean customers will necessarily leave Netflix for HBO. It might make the acquisition of domestic consumers harder but the service is only set to launch sometime next year!

It’s also very possible that the price hike affected the number of subscribers but as the CEO of Netflix himself put it in his letter to the shareholders, “Slightly higher prices result in slightly less growth..”.

Slightly less growth means exactly that, slightly less.

So why did Netflix lose about 25% of their market value?

 

September is historically the worst month for stocks. The standard narrative is that after a summer of light trading, perhaps due to people going on vacation, investors return to work and sell off stocks they’ve been meaning to get rid of.

This selling pressure likely contributed to the sell-off in stocks during the month of October. There was already a lot of nervousness in the market. We had been in a long bull market, one where stocks are rising, where the major stock indices were testing their record highs. The length of the bull market, and anxiety over the actions of Federal Reserve regarding quantitative easing measures meant all the conditions were ripe for a market correction.

The S&P 500 fell 10% from its record high last month, the Dow Jones Index fell about 7.5%, the Russell 2000 fell 12%, and the Nasdaq, 10%.

This was a serious decline which caused a lot of nervousness in the market. People were left wondering what to do; take profits and run? Or did the bull market, one where stocks are rising, have further to run?

In the end, we experienced a crash and the fear that lingered in the air likely exacerbated the stock drop in Netflix a week later.

 

So what does that mean?

It’s not the first time the market has overreacted to negative news concerning Netflix. The stock went from $285 to $55 and back to $485 in the span of 4 years.

According to estimates by independent research firms, Netflix was likely overvalued and $115 drop brought the stock back to about fair price.

Netflix is going to grow, with European expansion already taking place in September, so the stock drop represents a chance to buy some shares on discount.

Final Take-Away

Oh, and what about the overall market?

I didn’t forget about that. What’s an investor to do about the stock market correction?

It all depends on your level of risk tolerance.

You can choose to stay in the game, playing the sector rotation game and transition to late-economic cycle sectors like technology and telecoms.

OR

move a large percentage of your money into safer assets like bonds and cash and wait to see what the market does.

Either way, be careful!

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