Why I'm Bullish On This Pricey Stock

Joseph Hogue's picture

Friday, July 29, 2016 - 7:30am

by Joseph Hogue

Netflix (Nasdaq: NFLX) lost a staggering $6 billion of its market cap in one day as shares plunged 14% on July 19. The company's second-quarter earnings report was a shocking disappointment as subscriber numbers came in well below expectations.

Analysts were quick to cut earnings estimates and question target prices following the news, but this kind of post-earnings mayhem is nothing new for the world's largest streaming subscription service. In fact, data over the past 10 quarters shows double-digit price swings are the norm after the company's earnings announcements.

And historical data uncovers another interesting post-earnings trend that traders can take advantage of.

Bad News Can't Keep Netflix Down

Few stocks are as volatile as Netflix after it reports earnings. Looking at the past 10 earnings announcements, shares have fallen an average of 11% on disappointing reports and have gained an average of 13% when the company reports good news.

But a funny thing happens following the big post-earnings moves... the shares tend to move higher regardless of whether the company reports good news or bad.

Shares of NFLX moved an average of 6% higher in the month following the six earnings reports where the company reported good news. That's on top of the surge immediately following the release. Shares also moved higher after three of the four disappointing earnings releases, rising an average of 5% in the one-month period following the four negative releases. 

It seems bullish investor sentiment in Netflix can't be stopped.

Half of U.S. households have a streaming service, and Netflix dominates 89% of the market. Nielsen reports that 52.6 million American households had a Netflix subscription in May, twice the number of subscriptions of the next closest competitor, Amazon's (Nasdaq: AMZN) Prime.

Netflix reported subscriber adds of just 1.68 million in the second quarter, well under its April guidance of 2.5 million. The weakness was due to higher-than-expected subscriber losses.

Management noted that the higher churn rate may have been due to a misperception of headlines about the company's pricing policy. Netflix increased the monthly price for new subscribers from $7.99 to $9.99 two years ago, but allowed current subscribers to retain their old pricing for a while longer. The company is now converting existing subscribers to the new rate, and some customers appear to be balking at the additional cost.

Shares of NFLX plummeted following earning even though EPS beat analysts' estimates by 350% and revenue grew 28% year over year to $2.1 billion.

Despite disappointing subscriber growth, Netflix still dominates its space and ended the quarter with 79.9 million paid customers, up 27% from the same quarter last year.

On a valuation basis, shares still trade for an eye-popping 288 times trailing earnings, but that's down from a multiple of 341 before last week's earnings announcement. And we can take advantage of Netflix's post-earnings volatility with a simple covered call strategy.

Use NFLX's Post-Earnings Volatility To Your Advantage

If you're not familiar with how covered calls work or the many benefits of this strategy, you can get a 90-second crash course here.

Basically, a covered call involves selling a call option on shares of a stock you own to bring in additional income. By accepting this payment, you agree to sell your shares at a higher price (the option's strike price) if they reach that price before the option expires. Higher volatility means higher option premiums, which makes this the perfect time to be an options seller with Netflix.

With NFLX trading at $92.04 at the time of this writing, we can buy 100 shares and simultaneously sell one NFLX Sep 95 Call, which is trading around $3.07 ($307 per contract) for a net cost of $88.97 per share. That's a 3.3% discount to the current price.

If NFLX closes above the $95 strike price at expiration on Sept. 16, our shares will be sold for that price. In this case, we will make $2.96 in capital gains, plus the $3.07 premium from selling the calls, for a total profit of $6.03, or 6.8% over our cost basis of $88.97. Because we'd earn that in just 51 days, it works out to an annualized return of 49%.

Netflix has benefited in no small part from the success of its original programming, boosting investor sentiment every time a new smash hit is released. "Stranger Things," released July 15, seems to be all anyone can talk about on my Facebook feed, and season two of "Narcos" is scheduled to be released in September. Both could help boost shares heading into September expiration, while bullish investor sentiment and longer-term growth provide reasons to hold shares if they close below the call's strike.

Covered calls are one of the best ways to supplement your regular or retirement income. If you're interested in pocketing an extra $3,000 a month using this strategy, watch this video.

This article originally appeared on ProfitableTrading.com: Why I'm Bullish on This Pricey Stock

Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.