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Plenty of Drama with This Stock, and Earnings Might Be a Thriller

Richard is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There’s never a dull moment with Netflix (NASDAQ: NFLX). I crave popcorn and a large cherry Slurpee just watching the stock move. If you blinked, you’ve likely missed that it’s one of the hottest stocks on the market. With shares reaching as high as $104 last week, Netflix has doubled over the past 5 months after bottoming out at $52 in August.

Then again, this is a long way from the $300 level reached a little over a year ago. Nonetheless, this brings up an interesting play ahead of earnings. While management deserves credit for executing moves and turning things around, what then can be revealed in the Q4 report to prevent shares from selling off after such a run? Too, Netflix must prove that its enormous P/E of 127 still deserves time.

If You Build It, They Will Come

This has been the company’s M.O. for some time and thus the most popular bear argument. Despite the fact that the company has been making the right decisions of late, Netflix’s aggressiveness and the “grow at all cost” mentality makes investors nervous. However, in many respects, this strategy has worked. The question is, for how long?

There’s plenty to like with the operation. I just don’t care for the losses the company accumulates each quarter, which in my opinion will end up hurting the company in ways it couldn’t anticipate. On the other hand, I appreciate that the company’s future hinges on building its infrastructure and international expansion. But how long can Netflix absorb 90% profit declines as it did in Q3?

Though, when comparing to chief rival Amazon (NASDAQ: AMZN), whose Prime streaming service competes head-on with Netflix, the situation is not as daunting since Amazon also lost $274 million in its recent quarter. How - by aggressively building its infrastructure. Then again, it’s also true that for Amazon, Prime is only one segment of its revenue stream.

Still, I don’t think that Amazon’s limited library scares Netflix today. However, tomorrow may be a different story. Amazon’s recent deal with Epix and possibly one or two more may be what the company needs to expand its offerings. At the time, I questioned why Netflix allowed its exclusive Epix deal to lapse, presenting an opening for Amazon.

Then shortly thereafter, the answer was clear -- Netflix announced a content-sharing deal with Disney (NYSE: DIS). As Amazon proved, it only takes one deal to change the whole competitive landscape. Although the deal with Disney won’t take effect for 3 years, it’s encouraging nonetheless.

Plus, that it allows Netflix subscribers to stream Disney movies, as well as those from subsidiaries such as Pixar and Marvel, gives Netflix a huge advantage over Amazon. Although details of the deal are still unconfirmed, estimates suggest that it is worth close to $300 million per year.

If true, it’s yet another example of Netflix’s infrastructure bets as this would eat a great chunk (40%) of the company’s cash, which currently sits at $800 million. As noted, for a company already dealing with concerns about profitability this is a considerable premium to pay.

So far, the company’s growth has supported its infrastructure building strategy. However, at some point the bottom line will matter. And Netflix will have to answer for its expenses. Again, the good news is that Netflix has 3 years before it has to pay Disney, which now puts its fourth quarter earnings into focus – and in particular, its cash position and guidance.

Expectations for Q4

First and foremost, Netflix is going to report a loss for the quarter. Let’s just get that out of the way. The question is the magnitude. The Street expects a loss of 12 cents per share on $935 million in revenue. This would reverse a profit of $35.2 million, or 64 cents per share that the company earned last year.

Then again, it would represent 7% revenue growth – not nearly enough to support a P/E of 127, in my opinion. If there is not an upside surprise somewhere, the shares will sell off, especially (as noted) after having doubled over the past 5 months. Too, debt and rising content costs will be heavily scrutinized. Netflix has $4.5 billion due before the end of 2015.

That said, if Netflix can woo the Street with its subscriber growth, this can offset near-term fundamental concerns. In Q3, Netflix was able to gain 2 million new streaming members – bringing its worldwide total to 29 million. This is in addition to U.S. subscribers, which grew to over 25 million – up more than 20% year-over-year.

This means that streaming growth of less than 2 million will disappoint the Street. So will international subscriber growth of less than 750,000. Earnings will certainly be interesting and as the title suggests, get your popcorn ready.

Will Apple Press Play or Make a Play?

In the meantime, Netflix will continue to be the subject of M&A rumors. That the company’s market cap has been reduced over the past year makes Netflix an interesting acquisition candidate for Apple (NASDAQ: AAPL). If Apple truly endeavors to dominate TV, this is a deal Apple has to make. And I think an offer of $12 billion will seal the deal.

In a recent article, I offered 2 reasons why Apple should make this deal, including that Netflix’s 29 million paying subscribers could yield close to $30 billion to Apple in iTV revenue. But the only reason that matters is that Apple needs a way to effectively monetize iTunes’ long-term growth potential in movies. The competition so far is not making it easy.

Although Netflix’s deal with Disney will also present Apple with some leverage, it’s worth noting that Amazon has recently launched its own rival to iTunes. In that regard, Apple is already hurt by the fact that consumers insist that its a la carte model is expensive. Also, Apple does not have the breadth of content that Netflix enjoys. Working in Netflix’s favor is its sizable market lead. This deal would only cost Apple 12% of its current cash while likely solving many of its problems.

Bottom Line

Netflix is doing well in terms of growth. But I will continue to insist that profitability matters. At the moment, its rate of growth has earned the company time to grow its bottom line. But it’s not unrealistic to think that at some point Amazon and even the cable companies will apply pressure. Besides, Netflix has to do something about its growing expenses and mounds of debt.

Then again, if things fall into place, investors will continue to enjoy this show for a very long time. Meanwhile, popcorn may not be the only snack eaten during the show. Not if Apple has anything to do with it.


rsaintvilus is long Apple and has no position in other stocks mentioned. The Motley Fool recommends Amazon.com, Apple, Netflix, and Walt Disney. The Motley Fool owns shares of Amazon.com, Apple, Netflix, and Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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