NFLX – Two Big Problems for the Bulls on NFLX!

The 1st quarter results are out and the market has reacted.  Analysts on both sides -buy side/sell side – seem to be screaming at each other over the results.  As we said in our last NFLX blog, “We are sure quarterly reporting of NFLX will be a nail-biter over the next year”.

Old NFLX chart from our January 30, 2012 blog:

NFLX with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

New NFLX chart for April 26, 2012 (with 1st quarter financials)

NFLX with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

For those interested, a daily updated chart of NFLX subsequent to this post will be maintained on Facebook, here.

We made this prediction in our January 30, 2012 blog.

“The more interesting question is what happens when NFLX transits downward through EBV+7.  If and when this happens we think NFLX will find a more comfortable home at EBV+5.”

We have not changed our minds on this prediction; we think eventually NFLX will go to EBV+5 or $49.66.  Then assess at EBV+5, whether NFLX should go lower.

We cannot add much to the loud conversation, on both sides, about subscription adds and churns but we can look at our unique metrics and offer two troubling trends when we look at the balance sheet.

Theoretical Earnings (TE)

As we noted in our last blog when the company raised $400 million of additional capital, this raised TE from $1.43 based on NFLX’s September balance sheet to $2.06 at year-end.  With the 1st quarter report TE has risen again to $2.35, a 14 percent increase.

What does this mean?

NFLX will have to produce more in earnings in order to create valuation.  As we said in our last blog on NFLX, we like the use of an analogy of the marathon runner.  It’s easy to run a marathon at 143 pounds (based on TE of $1.43).  However at 206 pounds (TE of $2.06), the marathon runner is still the same person, can still run marathons, but the runner will have to work harder to run the same race.  More weight to move!  NFLX now weights 235 pounds (TE of $2.35).  NFLX needs at least $2.35 per share of earnings and above to generate a positive sloping model price.  (Currently, the mean estimate for NFLX is $2.82 for 2013.  Over the coming quarters it will be interesting to see this estimate and further changes to NFLX’s balance sheet.)

Longer Term we can look at the relationship between earnings pre share and theoretical earnings.

As you can see the spread between forecast earnings per share and theoretical earnings were widening positively.  The market, in particular, momentum stocks, trades on this relationship and will pay any valuation for this expanding differential.

The first step needed for NFLX to get its’ mojo back!

The first step needed would be for current, forecast earnings to surpass its’ theoretical earnings.  With theoretical earnings trending upward, the more earnings NFLX needs to at least reverse the slide in the stock.

Convexity

Convexity is friction.  Higher convexity means less friction.  When convexity moves lower in a meaningful way, valuation becomes harder to achieve because of, you guessed it, more friction.

Here is the history on calculated convexity for NFLX going back to 2004.  Convexity is now lower than any other time in NFLX’s recent history.

What does this mean?

NFLX will find it hard, if not impossible, to not only return to the valuation of 2010 -11, (EBV+10) but also the current valuation of EBV+6 is hard to justify with these changing fundamentals. (Higher theoretical earnings and lower convexity)

How do you find theoretical earnings and convexity on model price charts?

These calculations are included in model price.  So users don’t have to worry about individual variables in our model price calculation.  However, it’s fun for us to deconstruct what is going on “under the hood of the car”.

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