Netflix – Is the stock traders love to hate finally recovering?

And three compelling reasons to buy it

By Matt Blackman, CMT

It’s been a rough ride for Netflix investors. Without much warning, the stock began to drop in mid-July 2011 after the company divided its DVD by mail and online streaming services into two separate offerings, effectively doubling the price for subscribers in what can only be described as a public-relations disaster. Over the next four months the stock dropped from its July 13 high of $304.79 to a low of $62.37 on November 30, a collapse of more than 75%.

So was such a huge drop warranted?

Figure 1 – VectorVest7 real-time intraday chart of Netflix (NFLX) on January 4, 2012 showing the decisive move above the 30-day weighted moving average (white line) for the first in months even though the overall stock market action that day was tepid. The stock closed the day at $80.45 for a one-day gain of 11.5% on 5.3 million share volume, which is near the 50-day moving average of volume. Chart courtesy VectorVest.com

But what caused the complete about-face in stock action early January was the revelation that Netflix users watched more than 2 billion hours of content in the last quarter of 2011, far exceeding the 1.2 billion hours estimate of analyst Richard Greenfield at BTIG Research, who admitted that his guess was “far too conservative” according to Bloomberg.

It was clear evidence that rather than dropping the service as anticipated, its subscribers, estimated at roughly 21 million, seem satisfied enough with the streaming-only service to continue paying the $7.99/month subscription fee.

Reason #1 – Interesting Technicals

There are some good technical reasons why this stock is a compelling buy. First, it decisively moved above its 30-day weighted moving average on January 4 which was preceded by strong positive divergence in the MACD (middle window Figure 1) and the Detrended Price Oscillator (DPO) in the lower graph window.

NFLX also shows solid basing since the November 30 low as the stock continued to put in a series of higher lows and higher highs building a strong foundation. One of my favorite bottoming indicators, the Williams Capitulation Index (WCI) which I developed from Larry Williams’ VIX FIX Index, which creates a VIX facsimile for any stock, commodity or index, also shows strong capitulation in NTFX.  Unlike the VIX FIX, the WCI employs a volume calculation and this indicator hit extremes in mid-November, two weeks before the stock bottomed.

But as any trader worth his or her salt knows, daily technicals have a relatively short-term horizon and can change quickly.

Reason #2 – Compelling Longer-Term Fundamentals

Without a doubt, Netflix’s strongest fundamental asset is the fact that more than 20 million subscribers continue to pay the monthly subscription. Contrary to analysts’ concerns, there is no evidence that subscribership dropped significantly after the separation of services announced in mid-2011 if the latest Netflix news proves to be true.

Figure 2 – This end-of-day chart demonstrates why you can’t rely on the fundamentals to get you out of a stock, or in for that matter by solely relying on corporate data. Note that revenue and earnings numbers have continued to grow despite the more than 75% drop in the stock. Chart courtesy VectorVest.com

As Figure 2 shows, this is only the tip of the revenue iceberg. As we see, Earning per Share (EPS), Growth Rate (GRT), Sales Growth and Sales per Share (SPS) gave no hint that Netflix (NFLX) was about to fall out of bed back in July 2011.

In fact, the picture has only gotten brighter for the company from a revenue and earnings standpoint. As data from VectorVest.com on January 3 shows, forecasted EPS for the next 12 months is projected at $6.14 and 1-3 year earnings are projected to grow at an impressive 25% per annum. Sales growth is also impressive at 49% and Sales per Share has grown steadily to $52.83 per share. Not bad for a stock that was trading under $63 in November! At 25.21 according to VectorVest data, the PE for NFLX isn’t low, but not high for stocks in this space either.

It gets more interesting. According to a detailed analysis of NFLX by VectorVest, the Relative Value of the company based on its long-term fundamental appreciation potential is 1.42 which translates to a value of $102.58/share. However, given the big drop, the stock was still a recommended Hold on January 4.

Two other metrics worth examining are Earnings Yield (EY) and Growth to PE (GPE). EY which is the 12-month forecast for earnings is projected to be $6.14/share and GPE is 2.13 well over the undervalued/overvalued threshold of 1.00, another indication that the stock is undervalued. Both metrics have improved since the July peak above $300/share.

Many traders don’t pay much attention to the fundamentals which is odd. Given that a traders’ main job is to read market behavior and use his/her indicators to exploit it, why would they ignore a factor that rightly or wrongly motivates the majority of market players to buy stocks? Even though we know fundamentals lag and are poor tools for getting you in and out of the market in time, isn’t it important to know what this group is doing so you can gauge what’s driving “the crowd”?

And according to the above data, the fundamentals for NFLX look compelling indeed.

The next chart shows how much Netflix was punished last year compared to its industry rivals in the Internet E-Commerce sector. While the sector dropped 28%, NFLX dropped nearly three times that amount.

Figure 3 – This chart shows how poorly NFLX has fared against its peers in the Internet E-Commerce space in the last six months. Chart courtesy of VectorVest.com

Reason #3 – ‘Tis the Season

As commodity traders understand all-too-well, seasons are an important factor when buying and selling. But seasonal cycles are as important to stock traders and investors as well. Over the last eight years, Netflix has enjoyed an annual average return of just over 60%. But what is interesting is that the period from late July though the end of December has typically accounted for more than 30% of that gain on average. In the latest seasonal cycle this gain never happened.

This could mean one of two things. Either the company’s best days are behind it or the correction was overstated. If the latter case is the reality, Netflix has the potential to post above average gains just to get back to where it was July last year.

Figure 4 – Chart showing a composite of eight years of Netflix performance with typical early year weakness to the third week of January, a correction in July then strong performance into year-end. Chart courtesy of EquityClock.com

Possible Flies in the Kool-Aid

So far we have only looked at the positives in our Ben Franklin balance sheet approach to Netflix. Now is the time to consider the caveats.

As mentioned above, there is a chance that there are some fundamental core problems with the company that triggered the big price decline – problems with which the public is not yet aware. Any buy decision should be accompanied by a tight stop loss in case another skeleton comes out of the closet.

Secondly, Netflix revolutionized the television and video industry. It is a killer app that took the world by storm. However, they do have competitors. And what if another stronger app came along and did to Netflix stock what it did to BlockBuster and the rental video business in general?

Finally, there are many headwinds facing the stock market this year, such as massive global debt, continued challenges in Europe, high unemployment, an anemic economy, shattered consumer and investor confidence and Iranian tensions in the Strait of Hormuz, to name a few. There is always the possibility that any one of these could stop the rally in its tracks – another reason why stop losses are requisite.

But if we are in the early stages of a recovery that has some legs, Netflix has the potential to experience a nice bounce from here and even make an attempt at its past high. As always, it’s important to do your homework and/or trust that task to your financial advisor before acting on any information you read or hear.

Disclosure – Author does not own Netflix shares at this time but is a Netflix subscriber. He may buy the stock in the near future.

About the author:

Matt Blackman, CMT is the host of TradeSystemGuru.com. Matt’s articles have appeared in publications such as Technical Analysis of Stocks & Commodities magazine, SFO (Stocks, Futures & Options) Magazine, Trader Monthly Working Money, Physicians Money Digest, Laffer Economics, The Wellington Letter, Traders.com Advantage, Traders Mag (Europe), Active Trader and Investopedia.com. Matt is a member of the Market Technicians Association (MTA) and the Canadian Society of Technical Analysts (CSTA). He earned the Chartered Market Technician (CMT) designation and a B.Sc. (Honors) degree from Simon Fraser University.

Get Matt’s latest trading ideas and market comments on Twitter at http://www.twitter.com/MattBlackmanCMT

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