The Rise and Fall of Netflix

Shares of video streaming company Netflix (NFLX) plunged 15% this week after the company announced surprisingly weak first quarter results on Monday. It was trading above $130 four months ago, but since then NFLX has seen its share price fall back to where it was last July when it broke above $95 for the first time.

At the heart of the matter isn’t so much Netflix’s financial results, but its anemic growth in subscribers. The company now projects only 2.5 million net (of cancellations) new customers in the second quarter of this year, about 40% less than the 4 million increase analysts had built into their growth estimates at the beginning of 2016.

Just as surprising is the Netflix analysts were caught off-guard by this development. Based on the amount of insider information that gets passed around on Wall Street, especially about companies as popular as Netflix, you would think that a miss of that magnitude would begin seeping out weeks before the announcement.

In this case the company’s officers and directors had good reason to keep this secret under wraps. As Netflix’s share price zoomed up the charts the past couple of years, proponents of the stock have argued that earnings were secondary to capturing market share. But if the market share argument no longer holds water, then what is Netflix really worth?

We shall soon find out. Momentum stocks like Netflix exist in a parallel universe, where the conventional rules of investing do not apply. That’s why certain companies, such as Tesla, can garner a cult like-following that pays little regard to how much money the company actually makes. All that seems to matter is that they have a cool product that everybody seems to want, regardless of price.

At least, that’s what Netflix thought when it announced at the beginning of this year that it was raising its monthly subscription price by $2 to $9.99 starting in May for its legacy members, most of whom believed they had been promised by Netflix that their rate would never go up when they first enrolled. The challenge for Netflix is its costs are going up, so leaving this large pool of users at a fixed price indefinitely was becomingly increasingly less profitable.

That problem is further compounded by the fact that those same users now have many more choices for streaming video than they did five years ago, much of which is free or provided by cable companies as part of a bundle. Many of its legacy users had become loyal to Netflix before those cheaper options emerged, to the point that they were not inclined to seek out lower cost alternatives. However, all it took was one broken promise to bring Netflix’s real-life house of cards tumbling down.

The lesson of Netflix, and many other failed momentum stocks before it, is that ultimately financial results do matter, no matter how captivating the product may be. Burning through large amounts of other people’s money to gain market share only works if those customers can be converted to a profitable revenue stream before shareholders become impatient. That’s the same tightrope Tesla is now walking, hoping to safely reach the platform of profitability at the other end of the line before it gets knocked for a loop and takes the same plunge as Netflix.

What amazes me is how often this happens, and yet some people never learn. They allow themselves to buy into the “this time it really is different” argument, even though that same reasoning has failed countless investors before them. Even worse, it is painfully easy to spot an overpriced momentum stock since that data can be easily extracted from a wide variety of sources on the Internet.

That’s why I shake my head whenever an overvalued company such as Netflix eventually blows up and its shareholders claim to be blindsided by what must have seemed an unimaginable event. If you want to know why Netflix stock got hammered this week, the explanation is simple: it is only marginally profitable and pays no dividend, yet was trading at more than 100 times forward earnings.

At the risk of saying I told you so… I told you so. Or at least, my IDEAL stock rating system told all of us that NFLX was overvalued and at risk of a steep fall. It was recently featured in a PF Special Report as one of “10 Overvalued Stocks to Avoid RIGHT NOW!” By the way, Netflix is one of 26 stocks in the S&P 500 that earns the lowest possible score that my formula can assign. If you’d like to know who the other 25 are before its too late, click here.