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How Netflix Just Planned Its Death – And Recovery

The secret to effective management is to under promise, yet over-deliver.

Executives at Netflix

NFLX
(NFLX)
on Tuesday delivered terrific second quarter financial results, considering the bar had been set so low. And shares promptly scooted smartly higher.

The shares of other companies may not get the same Q2 earnings love. Let me explain.

Netflix gets a lot of hate. From a fundamental perspective, shares have always been expensive. Even now, with 220 million paid monthly subscribers, execs say the company will only generate about $1 billion in free cash flow in 2023. And this metric has been way worse through the years.

The problem is spending.

Long before the Los Gatos, Calif.-company made the innovative jump in 2007 to a streaming distribution model, executives spent lavishly to build out the infrastructure of the business. The first big spend was software, specifically compression algorithms and recommendation engines. Then came the mountains of cash used conjure up a content library. According to a report at the Hollywood Reporter, Netflix plans to spend $20 billion for media in 2023 alone, making it by far the biggest studio in the world.

While spending served the company well through most of its history, in 2021 headwinds began to develop. Subscription growth was slowing as the global economy emerged from the covid-19 lockdowns. That’s when Ted Sarandos, chief executive officer, decided to torpedo future expectations. It was an opportunity to begin telling a new story about the company.

It was a giant reset.

Following the Netflix Q1 results Sarandos said the streaming company might lose 2 million subscribers in Q2. He also shocked analysts with plans to revisit previous decisions that categorically ruled out advertising, and password-sharing.

Jump forward to Tuesday evening. With investors expecting the worst, Sarandos said Netflix lost only 970,000 subscribers, and earnings swelled to $3.20 per share, versus guidance of $2.98. Shares jumped 7.5% higher in after-hours trade.

There is a lot to like about Netflix. Advertising should grow subscribers significantly, especially in emerging markets where customers would rather watch commercials than pay a monthly subscription fee. And cutting back on password-sharing should help with subscriptions, too.

News leaked ahead of the Q2 results that Netflix was clamping-down on sharing in several Latin American markets.

Bullish investors often use Netflix as a technology company proxy. The streaming media giant reports results near the beginning of earnings season. It is also big business with a household name. The combination makes it tempting to wager that so goes Netflix, so goes the rest of tech. That is dangerous.

Netflix executives had their reset moment last quarter. Seranos saw a big opportunity to slash expectations and he took it. Shares fell precipitously. There is reason to believe that moment for the rest of tech is coming this quarter, and it may not be pretty.

Investors should be quite careful chasing recent gains. Specifically, I would be weary of many smaller Software-as-a-Service companies. Some of these stocks are 50%-70% off their highs. Nobody wants to admit, yet share price weakness makes it more difficult for smaller companies to raise capital, retain employees, and most importantly, win new business from larger companies.

Chief information officers in the Fortune 100 are weary of hitching their business to smaller firms that may fail, or get bought out in the future.

The bottom line is while Netflix shares may ultimately rally much higher from current levels, yet investors should be careful about ascribing its brighter prospects to the rest of tech.

The part when executives under promise might be straight ahead.

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