Why NFLX Stock Crashed
Over the last four weeks, Netflix, Inc. (NASDAQ:NFLX) lost $36.9 billion in value when the market turned against tech stocks.
However, fear wasn’t evenly spread among the FANG stocks: Facebook, Inc. (NASDAQ:FB) Amazon.com, Inc. (NASDAQ:AMZN), Netflix, and Google—now Alphabet Inc (NASDAQ:GOOG). Only two of those stocks crashed, and Netflix stock was one of them.
If you’re looking for the straw that broke the camel’s back, look no further than Netflix’s second-quarter earnings report. Revenue and income were on par with expectations. (Source: “FINAL Q2-18 Shareholder Letter,” Netflix Investors, July 16, 2018.)
However, the company underperformed in two specific areas:
- Subscriber growth: Netflix added less than 5.2 million new subscribers this quarter, falling short of the 6.2 million predicted back in April. Investors were disappointed in the results, although they might have been less disappointed had the bar been set lower.
- Forward guidance: Each quarter, Netflix tells investors what to expect for the next year. Those predictions have been getting worse rather than better, so it’s hardly surprising that investors took out their frustration on NFLX stock.
Since hindsight is 20/20, I could say these are dumb, self-inflicted wounds that Netflix should (and could) have avoided. But I think it’s important to recognize that making predictions is a tough business.
Unless Netflix has a foolproof Magic 8-Ball stowed away in its Los Gatos headquarters, the company is bound to make errors on occasion. What matters is how they react. Do they take responsibility for providing poor guidance? Or do they simply wave away criticisms that come their way?
In this case, Netflix acknowledged its mistake. The shareholder letter opened by saying [emphasis added]: “We had a strong but not stellar Q2.” And further down, it admitted that Q2 numbers were “over-forecasted” and are “low relative to our guidance.”
It was a humbling moment. NFLX stock surged 259% in the past 24 months, an epic run that probably had its management team feeling invincible. But then the market changed and we entered a bear market for tech stocks.
Chart courtesy of StockCharts.com
Should Investors Run From NFLX Stock?
I understand the fear. Netflix was the only fish in the pond for a long time. It had near-universal control of the market. But now that rivals like “Amazon Prime” and “Hulu” are getting serious, the moat that everyone thought was a mile deep is looking more shallow.
Netflix’s insane price-to-earnings ratio doesn’t help matters. A triple-digit multiple is fine during bull markets, but when fear seeps through the tech sector, everyone rethinks the definition of “reasonable.” That’s why valuations drop during a bear market.
That said, investors are possibly—and I want to stress the word possibly—panicking a little too early.
We’ve seen Netflix stock crash 13 times.
On one occasion, in October 2011, Netflix shares dropped 35% in a single day. Investors were so upset that the company was spinning off its DVD rental business that they abandoned it, despite an earnings beat.
Here’s a direct quote from news reports at the time [emphasis added]:
Though it still does have 23 million members, Netflix managed to make the kind of mistake so massive that people will study it at business schools for generations to come. The company had a remarkably successful movies-by-mail service, but decided it would be left behind if it kept sending DVDs to people instead of streaming them online. So it tried to spin off its mail service to a new business called Qwikster. Customers revolted.
(Source: “Netflix Stock Plunges After 800,000 Members Quit,” ABC News, October 25, 2011)
This actually happened. Pessimism overran Netflix stock. It was short-lived, though, because less than a week later, NFLX started a rally that would carry it up 2,925% to where it is today.
In other words, anyone who sold NFLX stock wasted a tremendous opportunity. They, like so many others, made the mistake of doubting CEO Reed Hastings, whose leadership has been visionary at worst and prophetic at best.
We seem to be entering a bear market for tech stocks. Investors would be wise to increase their cash holdings for the near term until stock values drop to enticing lows. However, at that point, I think Netflix stock is quite attractive.
Yes, I know that subscriber growth cannot continue indefinitely, and that Amazon Prime and Hulu will do their damage, but Netflix is synonymous with online streaming. It is woven into the cultural fabric in a way that’s difficult for competitors to overcome.
Also, Netflix is usurping HBO as the destination for premium content. It took home more Emmy nominations than any other television studio, breaking HBO’s 18-year winning streak. (Source: “Netflix Stuns HBO: Emmy Nominations by the Numbers,” Hollywood Reporter, July 12, 2018.)
Over time, this could mean that Netflix can charge higher membership fees, make higher margins, and consequently drive a higher share price. So, to conclude, the current crisis seems overblown.