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Netflix and the Media Meltdown

A special report issued by Colin Cieszynski, CFA, CMT, CFTe Chief Market Strategist, CMC Markets and Michael Hewson, MSTA, CFTe, Chief Market Analyst, CMC Markets

Following the news that many major media companies have sold off shares, Colin Cieszynski and Michael Hewson look at what has happened to the media industry and how Netflix has outperformed its competitors.

Within this report Colin and Michael discuss: • How the media industry has performed in the last week • How Netflix has fought back and outperformed its competitors • The pervious performance by Netflix and the market expectations for its future

This week, many of the major media companies have sold off shares steeply, as traders reacted negatively to their earnings reports. In particular, softer than expected sales have overshadowed better than expected earnings. The negative impact of the stronger USD Dollar and potential loss of subscribers from traditional media sources to streaming services such as Netflix, appears to have really spooked traders this week.

Last week, the negative reaction to Walt Disney’s earnings report sparked a sector wide selloff that continued with Viacom and 21st Century Fox taking the big hits after their own earnings reports.

Looking at the performance of the group over the last year, Netflix has gone from underperforming in the sector, through the end of 2014, to increasingly outperforming through 2015. The big question now is whether Netflix can continue to outperform or if it could potentially fall back to Earth.

Among the more traditional media stocks, Disney had been among the consistently stronger performers which perhaps explains why last week’s selloff came as such a shock to traders. Time Warner has also spent the last year in positive territory. On the other hand, Viacom has underperformed the group over the last 12 months, while CBS and 21St Century Fox turned downward in the spring.

Over the last week, while traditional media stocks have been tumbling, Netflix has been on a roll, rising more than 13%, while many of its more established competitors have posted losses of 10% or more.

An old adage of the market is that valuation is related to growth and that high multiples can be supported by high growth rates (as long as they last). One measure that can be used to compare valuation and growth is the P/E to earnings growth ratio, the last line on the table. Most of the majors in the sector studies have a ratio between 0.5 and 2.0 (with 1.0 being the par level) while Netflix has a ratio above 14.

Netflix shares appear to be very expensive in relation to other companies in its group and potentially vulnerable. Netflix really needs to keep its growth to justify its share price, but they could be in trouble if they start to stumble. Last quarter, Netflix only met expectations on sales and missed on earnings, which was ignored by the markets in favour of its growth potential, making it increasingly vulnerable if the company ever fails to meet very inflated expectations.

Netflix shares may already be close to reaching their limits. Although the shares have continued to make new highs since April, these have not been confirmed by the RSI indicator. A growing negative divergence reflects slowing upward momentum. Also, in the last few weeks, the shares have moved above their longer term rising channel, suggesting they may be getting ahead of themselves.

The shares may be getting tired - after a gap through $120.00 earlier in the week, the shares have been consolidating between $122.00 and $129.00 being unable to proceed much further. An overbought RSI suggests the shares may be due for a pause and a correction is possible.

If the shares fail to hold above the circle $120.00 to $122.00 support zone, a correction would be underway that could drop back to retest the former channel resistance line near $113.00. A gap through the circled zone would create an island top and potentially trap some of the bulls offside.

Netflix shares have had a strong run in recent months on growing speculation that the service could eat its competitors’ lunch. However, Netflix shares have reached such a high valuation relative to their competitors, they remind us of the days of the technology bubble. With Netflix shares having priced in incredibly high expectations (seemingly that Netflix could wipe out the current broadcasting and cable industry in one fell swoop) it wouldn’t take much for the bubble to burst increasing the potential that the higher NFLX shares go, the more likely inflated valuations and expectations could come back to haunt them.

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