Netflix rally on earnings tells us more about how complacent this market than about Netflix

This market remains determined to rally as we head into earnings season.

Look no further than the reaction to earnings from Netflix (NFLX) for evidence.

The stock market could have reacted to yesterday’s earnings from Netflix (NFLX) by selling down the shares.

Could have. But didn’t.

In after hours trading on Monday, January 22, post the company’s earnings news, the shares climbed 8.5%. Today, January 23, shares climbed 9.98%.

The market clearly liked what it heard–and decided to just about completely ignore a totally plausible negative story that was available in the earnings report. The market’s decision to go with the positive revenue growth story and bid up the shares, and to ignore the negative story about soaring costs and elusive profitability, tells you just about all you need to know about the state of market enthusiasm as we head into the meat of earnings season.

For the fourth quarter Netflix reported earnings of 41 cents a share, which was spot on Wall Street projections for 41 cents for the quarter. Revenue rose 32.6% year over year to $3.29 billion, which was slightly above expectations for $3.27 billion in revenue.

Nothing here to push the stock up another $25 a share after its $40 a share gain in December. Even if the company did raise guidance for the first quarter of 2018 to 63 cents a share on revenue of $3.69 billion. At some point, you’d think this improved guidance would have been baked into the stock price.

What blew investors and traders away, though, were the subscription numbers. Netflix added a net 8.3 million more subscribers for its streaming service in the quarter. That was the biggest add in the company’s history. Even in the United States where half of U.S. households already subscribe to Netflix, the company added more net customers in 2017 than it had in 2016. The total of 8.3 million net new subscribers (with 6.4 million international customer adds and 1.98 million U.S. customer adds) was stunningly above the previous 6.3 million guidance.

As a revenue growth story this is strongly positive. It argues that Netflix has such a big footprint in the streaming media sector that no one is going to be able to dislodge it.

And that’s the story that Wall Street ran with yesterday and today.

But there was another story in the fourth quarter numbers.

The cash costs for the streaming programming that Netflix used to pull in those new customers rose to $8.9 billion in 2017. That cost has just about doubled from 2015. Netflix isn’t covering that cash cost out of cash flow either. Operating cash flow is deeply negative. For the full 2017 year the company showed a negative $1.8 billion in cash flow from operations. On Monday Netflix forecast that the negative free cash flow number would climb to $3.8 billion to $4 billion in 2018.

Where’s that cash coming from if not operations? Selling debt. Netflix sold $3.02 billion in debt in 2017. (The company finished the year with $2.8 billion in cash and cash equivalents.)

If you wanted to construct a negative story about Netflix from Monday’s numbers it would start with the huge negative cash flow number. And then worry about the company’s ability to raise money at a relatively low cost in the debt market with interest rates rising. (In the letter that accompanied its fourth quarter financial report, the company did note that it was confident that it would be able to continue to raise money in the high-yield market. Three cheers for that confidence. A bit of worry, though, about the mention of high-yield debt.)

The company already carries $6.5 billion in long-term debt, up from $3.4 billion at the end of 2016. Total liabilities came to $15.4 billion at the end of 2017, up from $10.9 billion at the end of 2016.

I’m not saying that any of this means that Netflix is about to crash and burn. But I do find it disturbing that these real issues didn’t make it into the reaction to fourth quarter earnings.

This is a stock, after all, that trades at 250 times trailing 12-month earnings per share.

It worries me–more about the market as a whole than about Netflix in particular–that the stock blew past these worries without a thought.

I’d have to conclude that this is really good news from anyone long this market (as I am) and looking for a continued rally on fourth quarter earnings reports (as I do.) But it is worrisome if you’re thinking (as I am) that in a slightly longer time frame this market is over-extended, complacent, and headed for what I hope will be a constructive but still painful dip as we move beyond earnings season.