One of the many things that the younger among us find funny about old people is their tendency to repeat themselves, so I guess my doing so could be seen a sign of my advancing age. I would argue, however, that at least when it comes to talking about moves down in a company’s stock following an earnings beat, I do so knowingly and with purpose.
It is one of the most frustrating things for investors, especially when it happens to a high-profile, widely-held stock such as Netflix (NFLX), and understanding why it happens is essential to understanding how markets work in general. I therefore make no excuses for looking at the phenomenon, even though I have done so in the past.
Such a seemingly counterintuitive move is usually for one of three reasons. Sometimes it is a combination of two of those things, but the reaction of NFLX to yesterday afternoon’s earnings report was the result of all three coming together.
In case you missed it, they reported earnings of $0.30 per share, easily beating the consensus estimate of $0.24, yet the stock, after jumping on the beat initially, settled around four percent lower than yesterday’s close.
An earnings beat is good news by definition but is inherently backward looking, whereas markets essentially attempt to predict the future. That explains the first two reasons a stock often drops on a beat, a revenue miss or lowered guidance. Higher than expected profits don’t necessarily mean higher than expected sales and, while they represent quite literally money in the bank, they tell us nothing about the main driver of a stock’s price: future prospects.
Sales and, even more importantly, forward guidance, are more significant in that respect, and in both of those areas, Netflix disappointed yesterday. Revenues of $4.19 billion came in just under the expected $4.21 billion and guidance for the first quarter of 2019 was for profit of $0.56 per share, well short of the expected $0.82.
So, even though they had a good Q4, NFLX dropped in after-market trading on the report.
But even with those misses, things might not have gone the way they did if it weren’t for the third, and probably most influential short-term factor in post-earnings performance: market positioning.
NFLX has had an incredibly strong run since Christmas and is up over fifty percent from the December 26 low. That suggests two things. First, the expectations of traders and investors were even higher than those of the analysts that cover the stock, and second, most of those looking to buy NFLX already had.
In trader-speak, the market was long going in, making it likely that there would be an exaggerated reaction to bad news and a muted one to good.
The drop on a beat is understandable in the context of those three things, but, beyond the obvious immediate impact, should that be a cause for concern for shareholders of Netflix? The other key numbers released yesterday, for subscription growth, suggest not.
On that front there was a lot of good news. Global subscriptions grew by 29 million last year, a 33% improvement on growth in 2017. More importantly, international subscriber additions came in at 7.31 million, substantially higher than the 6.14 million expected. One of the knocks on Netflix has been that the domestic U.S. market is close to saturation point, but there is still plenty of room for growth overseas so robust international growth numbers are a big plus.
The media business is incredibly hard right now. Competition is rife and forces companies like Netflix to burn a lot of cash on content generation. Where they score over more conventional media companies is that the other negative in the industry, weak advertising revenue, doesn’t affect them. They rely on subscriber revenue, and that is growing substantially where it matters most.
The sticky nature of that revenue and the size of the potential market both indicate that Netflix has a long way to go, and investors should, armed with the knowledge of why the stock dropped on a beat, just ride out this short-term move.