Should investors chase Netflix to new highs?

They've been volatile and prone to disappointment, but Netflix pulled it out of the bag in Q3. Lee Wild explains why the stock shot up as much as 21% on these numbers. 

Tech stocks there have been pounded this month. A few hiccups from sector leaders and wider market unease wiped 9% off the Nasdaq Composite in quick time. Now, third-quarter results season is bringing buyers back to the table, and Netflix is grabbing all the headlines.

All the talk is about a record surge in third-quarter new subscribers of 7 million to 137 million in all. That's 31% more than this time last year and smashes forecasts for 5 million. Crucially, growth was broad-based, and the movie and TV streaming business now expects a further 9.4 million subscribers over the next three months.

Netflix, responsible for hit shows like Orange is the New Black, Better Call Saul and Stranger Things, made a net profit of $403 million in the quarter, three times more than a year ago on revenue up more than $1 billion to a whisker under $4 billion. Wall Street had pencilled in earnings per share of 68 cents, so the 89 cents reported was well-received.

Operating margin also ballooned by 500 basis-points to 12%, 150 basis points ahead of estimates. However, both the margin and profit beats were flattered by a chunk of content and marketing spend shifting to the fourth quarter, so expect more modest full-year margin of 10-11% and net profit of just $105 million.

This is a much-needed boost for Netflix following a disappointing second-quarter when new subscribers fell short of expectations by 1 million. Its stock price slumped by 14% on that news and within a month was trading below $311, making a two-month drop of 26% from the June peak of $423.

And a flurry of buy orders in after-hours trade Tuesday had Netflix back at $405 briefly, before ending the evening session up almost 11% at $384 (both levels marked in red on the chart below). At its peak on Tuesday, the stock was up 21% from the previous session's close.

Source: TradingView (*)      Past performance is not a guide to future performance

Netflix's stunning success since its IPO in 2002 is legendary. If you missed the IPO price of $15, you could still have bought stock at $16.75, equivalent to $1.20 in today's money following adjustments for stock splits. Eyewatering stuff!

After a performance like that, it's perfectly understandable that investors should get twitchy at these levels. But Netflix is growing faster than expected and, while there will be glitches, the recent sell-off proved a great chance to buy into a unique story at a significant discount.

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Analysts at UBS pencil in earnings to double this year to $2.62 per share, then add a further 61% in 2019 and almost two-thirds more the year after to almost $7. That will be driven by rapid growth in subscriber numbers, tipped by the broker to hit 146.5 million by the end of 2018 and add an extra 50 million in 2019.

Given there’s no dividend here, it's all about growth. If Netflix does these numbers, or better, it will be richly rewarded. But, as with all these highly-valued tech stocks, they're priced for perfection, so slip-ups are punished severely.

Rising US bond yields bring extra trouble, especially for growth stocks like Netflix as investors will at some point decide that the return on risk-free Treasuries is preferable to owning much riskier equities.

Of course, Netflix remains vulnerable to events outside its control, but it's been hugely successful delivering what consumers want and at an affordable price point. If it delivers the kind of growth UBS expects, it backs the shares to reach $400 again. 

And these are not bullish estimates by any means - UBS only rates the shares as 'neutral'. What the broker does is acknowledge long-term secular growth and subscriber momentum. 

*Horizontal lines on charts represent previous technical support and resistance.