October 25, 2011 / 11:53 AM / 6 years ago

More challenges seen for Netflix, shares drop

5 Min Read

(Reuters) - Wall Street is losing confidence that Netflix Inc can quickly reverse subscriber defections and cover mounting costs with growth in streaming, pushing its shares to their largest one-day decline since 2004.

The stock nose-dived in heavy trading on Tuesday, a day after the company provided uninspiring guidance as it grapples with the fallout from an unpopular price increase and recent missteps.

CEO Reed Hastings, once viewed on the Street as a CEO who could do no wrong, is struggling to restore his and his company's tarnished credibility following a chain of strategic about-faces and unpopular moves, starting with a miscalculated price increase announced in July.

It culminated in Monday's shockingly dismal subscriber numbers and forecast, and a prediction for a loss, as the company pursues a costly global expansion.

Several analysts cut their ratings or slashed price targets, pointing to challenges such as rising costs for online movie and television content and international expansion.

"We believe the (Netflix) model is unsustainable, as the company faces rising costs that it hoped it could pass onto its (subscribers), who appear unwilling to do so," Janney Capital Markets analyst Tony Wible said in a note to clients. The brokerage cut its rating on the stock to "sell."

In the second-heaviest day of trading in the company's history, Netflix shares closed down 35 percent at $77.37 on Nasdaq -- 75 percent lower than their high of about $305 in July. It was the biggest one-day drop since October 2004, when the much smaller company lost 41 percent after it warned of growing competition. That day also saw the highest trading volume for Netflix shares.

The recent downward spiral for the shares started in July when the company that shook up Hollywood with its DVD-by-mail service announced a price increase for subscribers who wanted both DVDs and online streaming. Since then, its market value has shrunk by about $9.76 billion.

Netflix had drawn heavy short interest when its shares were on an upward tear and traded at nearly 50 times 2011 earnings.

One investor who had famously shorted Netflix shares in late 2010, Whitney Tilson, said on Tuesday he was taking a small, long position. Tilson, who had warned about the company's high valuation, had closed his short position in February as the stock kept rising.

In an email on Tuesday, Tilson said it was "frustrating to see our original investment thesis validated, yet not profit from it."

"In light of the stock's collapse, we now think it's cheap and today established a small, long position. We hope it gets cheaper so we can add to it," Tilson said.

Another investor who has shorted the stock at various times this year remained bearish on the stock. Yoni Jacobs, portfolio manager for Chart Prophet Capital, said he covered some of his short position on Tuesday but saw challenges ahead.

"I do expect Netflix's problems to continue," Jacobs said, in part because "I see them continuing to struggle with acquiring content."

As of October 14, roughly 18 percent of Netflix shares were shorted.

Expanding as Content Costs Rise

On Monday, Netflix -- which is trying to recover from the roughest patch in its nearly 15-year history -- forecast a loss for the first quarter of 2012 as it spends more to expand into Europe.

"Expansion into the U.K. and Ireland -- a positive longer-term -- comes at the same time domestic growth is slowing and content costs are building," said J.P. Morgan Securities, which downgraded the stock to "neutral" from "overweight" and slashed its price target to $67 from $205.

Citigroup also downgraded the stock to "neutral."

Coming into the session options traders had been expecting positive news. In the 10 trading sessions heading into Netflix earnings beginning with October 11, investors bought 1.24 call options - an option to buy the stock by a given date at a specific price - for every put option on major U.S. options exchanges, according to Joe Bell, senior equity analyst at Schaeffer's Investment Research.

"People were betting on a better report than what was released," Bell said.

Schaeffer's total put-to-call open interest ratio (SOIR) based on the front three months of Netflix options stood at 0.99 as of Monday. That's lower than 90 percent of the readings over the past year, which shows more calls added than puts in recent months, suggesting expectations for gains in the stock in coming months.

Netflix, in a letter to shareholders, admitted it had "hurt our hard-earned reputation" but said the company would return to profitability by "increasing our global streaming subscriber base faster than we increase our costs."

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