Felix Salmon

Why Netflix stock is so volatile

By Felix Salmon
October 25, 2011

netflix 2011-10-25.png

Daniel Indiviglio looks at the impressive plunge in Netflix’s stock price, both today and over the past three months or so, and wonders what on earth could have happened in the real world to justify such a plunge.

Even if its stock was overvalued at its July peak, a 74% drop in a little over three months is enormous. Was it really that overvalued? The company may now be undervalued: investors may be overreacting.

Indiviglio’s main point is well taken. The standard view of stock markets is that they’re some kind of objective collective judgment on the fundamental outlook of a company. The company does whatever it does, generating revenues and profits and cashflows and the like, and then the stock market places a present value on those fundamentals.

Under that model, the price action in Netflix makes no sense.

But that model doesn’t reflect the real world. In the real world, many companies — especially ones with high-flying stock prices — become self-fulfilling stock-price-appreciation machines, at least until the party stops.

And what’s happening to Netflix’s stock price has everything to do with Netflix’s stock price, and very little to do with Netflix itself.

Whitney Tilson, famously, was one of many people who went short Netflix at about $180 per share and busted out when it just kept on rising. Netflix, as the chart above quite clearly indicates, was for a very long time a steamroller which would just flatten anybody who tried to short it. And so the shorts went away, bruised, bloodied, and beaten.

Without short interest, there was almost nothing keeping Netflix stock in the realm of sanity. If you wanted to buy it, you needed to find somebody willing to sell it. And with the stock going ever upwards, such people were very hard to find. The stock had its own dynamics, which became increasingly divorced from any corporate fundamentals.

Or, more accurately, the stock dynamics became entrenched within Netflix’s corporate fundamentals. The deals I wrote about yesterday — like paying $30 million per movie for the right to stream DreamWorks’s animated films months after they’re available on DVD — were cheap when they were essentially being paid for with bubblicious Netflix equity. Indeed, insofar as they caused the stock price to rise, they had negative cost to Netflix: the more deals like this that Netflix did, the more valuable Netflix became.

But then the stock started falling, and all those dynamics were reversed. In a normal company with some kind of short interest, a falling stock price is met with shorts taking profits and supporting the price. In this case, the shorts were few and far between, and they too were enjoying the momentum trade. They weren’t covering.

Indeed, short interest started going up, rather than down: all the momentum traders who were happy making money on the way up were equally happy to try to make even more money on the way down.

And suddenly investors started looking at corporate fundamentals, and asking questions about whether streaming operations could ever be hugely profitable for Netflix — or even profitable at all. The dynamics of the rising share price were clear: every time that Netflix looked as though it was making lots of money, the price of the next streaming deal would only go up. Netflix has to buy streaming rights from big-media companies, and those companies are going to extract as much money as they can from Netflix, up to and possibly even beyond the point at which it declares bankruptcy. It’s the big-media companies which have the pricing power here, and now that Netflix has set eye-watering precedents for things like DreamWorks Animation and House of Cards, it’s going to find it difficult to pay more reasonable rates going forwards.

So people with equity in Netflix are in a difficult place. Their company is locked into a model where it pays billions of dollars for streaming rights, while keeping the price to subscribers dirt-cheap. That’s a model which on its face looks much more attractive to the content creators than it does to Netflix. And it’s very hard to place a value on the permanent equity of Netflix in that kind of dynamic. When it was going up, it was going up. But now it’s crashed so dramatically, no one has a clue where Netflix stock should be trading, or even whether Netflix — having largely abandoned its DVDs-by-mail business model — even has a viable model at all.

12 comments so far | RSS Comments RSS

They killed the golden goose. Might have had a strong “first mover” advantage in streaming, but by pissing off their customer base they have done their best to negate that.

The spiraling stock price led to their downfall. To justify that kind of P/E, they needed to find some way to squeeze additional cash out of their customers while continuing to expand their customer base rapidly.

Hard to achieve that — you can typically manage price increases or volume increases, but not both simultaneously. Not of the magnitude necessary to justify the share valuation.

Posted by TFF | Report as abusive

I have never had a problem with them. No one forces anyone to use their services. Living about 90 miles round trip from a movie house, I am very glad for their services.

Posted by sophiewonderful | Report as abusive

And yet, they are still around or above where they were 18 months ago.

I dropped the DVD service when the price change went into effect–and it was only that late because they didn’t process the change the month I made it.

As noted elsewhere–including by you–the Streaming service is all right, but Hulu and Amazon Prime are all right, too. Not to mention that DVDs (and some Blu-Rays) are Priced to Sell at a level comparable to NYC Street Vendors ca. 2006.

Incenting people to drop the one thing that makes you unique–the DVD catalog with broad appeal (i.e., more kids’s and family shows than Felix’s alternative suggestions)–is rarely a good business plan.

As sophiewonderful notes, we’re not forced to use Netflix. Someone should have told Reed Hastings that a few months ago.

Posted by klhoughton | Report as abusive

“The standard view of stock markets is that they’re some kind of objective collective judgment on the fundamental outlook of a company. ”

Um, Felix, could we agree that you will never use this phrase again? It’s been disproven in so many cases during the last, oh, millennium that it’s no longer useful, even as a rhetorical foil. (“But now we see that, quelle surprise (hat tip YS), stock bubbles do occur!”)

Of course “rational expectation” is always correct ex post facto — once we’ve figured out what the fundamentals actually were. It keeps us sane — and hopeful — and allows us to make the same mistake in the future, sans peur et sans reproche (hat tip CdB).

Posted by jbernar | Report as abusive

And what other companies fit this picture? Hmmmm Apple perhaps? Is Apple worth half a trillion dollars according to the stock price? Really? I wonder what will happen the second Apple’s tablet sales start to hit the skids, or iPhone saturation is reached and people start going to “the next big thing”?

Short of the century if you have the timing down? ;)

Posted by skyman123 | Report as abusive

skyman, the comparison to Apple is not valid. At its peak, NFLX was trading at about 75x earnings. Apple is trading at less than 15x earnings. Maybe you should have picked Amazon, which was trading at over 100x earnings, until they announced earnings today.

Given that Apple is priced lower than the average growth stock, the possibility of their growth leveling off or crashing has already been priced into their stock.

disclosure: I own Apple stock. I’ve been saying for the last 3 or 4 years I’m going to sell it soon, but their competition is so incompetent, I can’t come up with a good reason to do that.

Posted by KenG_CA | Report as abusive

I may be talking about my ass here, but…

Say tomorrow someone invented streaming hamburgers. And, say, the next day McDonald’s assured the market that it understood “changing times” and would corner the world of streaming hamburgers the way it had cornered the world of the non-streaming variety.

The market would bust a nut.

“Naturally,” says the market, “let’s throw money as this massive venture. McDonald’s understands and dominates the world of non-streaming fast food better than anyone else. In fact, it’s not just the non-streaming hamburgers itself but the non-streaming delivery of those burgers it gets. From top-down, here is one of the few companies that ‘gets it’ in a [reference Steve Jobs somewhere in there] changing world.

“Therefore, let’s follow it, lemming-over-fist, as it builds up its non-streaming side. And let’s forget that massive piles of debt are piling up like so many napkins when we eat the McRib. And let’s forget that, unlike non-streaming hamburgers, McDonald’s doesn’t actually own streaming hamburgers (yet, by the rules of accounting, those contracts are counted as an asset).

“We know this non-streaming hamburger business is happening. We know that only McDonald’s has the experience and know-how to make it happen. Let’s do this thing and build our confidence upon this House of Wrappers.”

And then, after years of an echo chamber of confidence dominating this discussion, the execs announce a plan that chases customers away, reminds the market of all that debt piling up and wakes people up to the fact that, really, no one needs McDonald’s for streaming hamburgers… yeah, the stock suffers a bit.

Posted by JohnFlowers | Report as abusive

“Or, more accurately, the stock dynamics became entrenched within Netflix’s corporate fundamentals. The deals I wrote about yesterday — like paying $30 million per movie for the right to stream DreamWorks’s animated films months after they’re available on DVD — were cheap when they were essentially being paid for with bubblicious Netflix equity. Indeed, insfoar as they caused the stock price to rise, they had negative cost to Netflix: the more deals like this that Netflix did, the more valuable Netflix became.”

I don’t quite follow this….did Netflix pay Dreamworks in stock?

How does the yo-yo stock price affect Netflix’s underlying business operations?

Posted by djiddish98 | Report as abusive

NFLX’s problem is that they think exclusive content is valuable. It’s not… it’s just expensive. If Sony makes a movie to distribute to thearters, DVD, and cable TV and NFLX wants a 30 day exclusive window then they need to pay up bigtime for that content and their customers must bear that high cost.

Don’t make me pay more so that someone else can’t view something. Make me pay as little as possible and still give me access. That’s the value of NFLX…

You can get any best selling book at Walmart, Target, Amazon, Barns & Noble, or any local bookstore. Nothing is gained by the publisher or the consumer by saying ok now we’re only going to distribute through 1 channel for a 30 day window.

If NFLX just keeps offering 10,000 hours of quality streaming content in a dozen different catagories for $9/month they will continue to grow their customer base at an exponential rate for years to come… the Dreamworks deal was foolishly overpriced… hell while the shares were over $250 they should have just bought Dreamworks outright in a stock transaction.

Posted by y2kurtus | Report as abusive

Netflix doesn’t own content, and it doesn’t own the means by which content is delivered. All they own is a series of rights contracts, a website, and a few interesting algorithms for suggesting content to users. There’s no moat. Owners of content can deliver it themselves on the web without Netflix, if they choose. Owners of the delivery method (cable companies, telecom companies) can offer the content bundled with their existing packages, if they choose. Long-term, if it is profitable, they will.

Posted by haggers | Report as abusive

I believe that I have some viable solutions that Netflix can implement to save (or, to help to save) their company from imminent demise (as the competition for digital screening consumers increases). My only problem is that I do not know exactly to whom I should address this information. Any suggestions?

Btw, yes, I would like to be compensated for this information if utilized.

S. J. Dowd

Posted by sarajd2012 | Report as abusive

Also, anyone with information that would help me to submit my information please contact me saraj_ spiritualhelp ya hoo


Posted by sarajd2012 | Report as abusive

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