Can Netflix Become Boffo Again?

12/03/2008 11:00 am EST

Focus: STOCKS

Jocelynn Drake

Financial Analyst, Schaeffer's Investment Research

Jocellyn Drake of Schaeffer’s Investment Research says the video rental company’s stock is suffering extreme investor pessimism that could cause it to test its lows.

The shares of Netflix (Nasdaq: NFLX) have failed to shake off the [market’s recent] doldrums. The company received a little positive news when Friedman Billings & Ramsey initiated coverage of the stock with a Market Perform rating.

[But] brokerage firms have a slightly bearish leaning toward the shares. According to Zacks, the company has earned four Buy ratings, five Holds, and one strong Sell.

Meanwhile, the average 12-month price target for NFLX stands at $27.40, according to Thomson Financial. This target is a 20% premium to the security's current trading price [of around $23], which is far from the exuberant price targets we have seen on many other companies.

Netflix operates a DVD rental service through its Web site. The company offers more than 90,000-plus titles to more than 7.5 million subscribers for a monthly fee. The movies are delivered to customers through the US Postal Service. Netflix does not charge late fees or have due dates. Netflix has a network of distribution centers in major US cities.

Pessimism toward NFLX can be found in the stock's options backdrop as well. The Schaeffer's put/call open interest ratio (SOIR) for NFLX stands at 1.86, as put open interest nearly doubles call open interest among near-term options. This reading is also higher than 80% of all those taken during the past year. In other words, options players have been more pessimistic toward the shares just 20% of the time during the past year.

In fact, the International Securities Exchange (ISE) has seen a surge in put trading on NFLX. During the past ten trading sessions, the ISE has reported an average of 24.5 puts purchased to open for every one call bought to open. This ratio of puts to calls is at an annual peak, pointing to extreme levels of pessimism among options players.

Short sellers have flocked to this stock to take advantage of its overall weakness. More than 17.6 million NFLX shares have been sold short, accounting for more than 37% of the company's total float. What's more, this accumulation of bearish bets is more than 19 times the stock's average daily trading volume.

Simply put, there is ample sideline money available to fuel a significant rally in the shares. Unfortunately, NFLX has given these bears little reason to unload their short positions.

From a technical perspective, the security has been breaking down since reaching a peak of $40.90 in April 2008. As a result, it has retreated more than 45%. The shares are currently consolidating into resistance at their ten-week moving average (currently between $20 and $25)—[above which] NFLX has not logged a weekly close since the beginning of October.

A rejection at the stock's ten-week moving average could send the shares down for yet another test of former support in the $18 to $20 region. This area has provided key support for the shares in the past, and could once again halt the security's retreat.

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