Expect Netflix Shares To Drop After Rally As Margins Fall, Profit Vanishes

Shares of Netflix (NFLX) surged nearly 15% to $108.75 in after-hours trading on Wednesday after the company easily topped analysts' expectations for the fourth quarter. Estimates called for the company to post earnings of 55 cents per share on revenue of around $858 million. The actual numbers were 73 cents per share on $876 million in revenue. Investors cheered the fact that Netflix was able to add 600,000 new subscribers in the quarter, which seems to indicate that the bleeding occasioned by last year's 60% price increase may have finally stopped. Today's report at least partly vindicates the rally Netflix's shares have staged since falling to a 52-week low of $62.37 in late November. The stock is up 37% this year alone, and that's not counting the rally that will inevitably come once the opening bell rings on Thursday morning.

Unfortunately for Netflix, the recent gains are likely to prove fleeting as reality continues to kick in for the company. For starters, the company's profit was down 14% from last year's fourth quarter. Additionally, the subscriber 'gains' during the quarter only look good against the backdrop of the 800,000 subscriber exodus that took place following the announcement of the price hike last July. To put the quarter's subscriber growth in perspective, consider that "the company [actually] added 25% fewer subscribers than in the fourth quarter of 2010" according to the LA Times.

In its report, the company said it expects to add 1.7 million new streaming customers during the first quarter of 2012, a move that "will be offset by cancellations of DVD-by-mail rental plans which Netflix is gradually phasing out," according to USA Today. Thanks to the company's decision to break-down its numbers by segment, investors can now clearly see that phasing out the DVD-by-mail service sounds like a better idea than it actually is. Regardless of how antiquated physical DVDs may become, the fact is that renting them out to customers is a high margin business compared to streaming content which requires Netflix to "pay high fees to obtain streaming rights to exclusive programming, as well as video already available in other outlets and formats." The difference in the profitability of the two segments is demonstrated by the fact that currently, the DVD-by-mail segment accounts for around 79% of domestic profits--193.765 million of $246 million--but less than half of total revenue. If you count the company's international streaming business, the streaming segment actually lost $7.633 million in the fourth quarter. What Netflix is telling its investors then, is that it is gradually phasing out the only profitable business it has.

What is most disturbing about the run-up in shares of Netflix, however, is the fact that the average estimate for the company's 2012 earnings per share is -2 cents. That's right, negative two cents. That means it is impossible to say just how overvalued the stock is based on its forward price-to-earnings ratio because it likely will not have any earnings this year on which to base a calculation. In the interest of putting a number to the speculation that is the rally in shares of Netflix, let's just assume the company earns 2 cents in 2012 instead of losing 2 cents. That means that based on the after-hours stock price of $108.75, the shares currently trade at 5,438 times forward earnings. I would immediately buy put options on shares of Netflix. The good thing about purchasing puts on Thursday is that thanks to the rally occasioned by the earnings report, they will be much cheaper than they were Wednesday.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in NFLX over the next 72 hours.