Netflix caught in perfect storm

Want to know why the company had such a spectacular rise and fall? Blame management, but also blame the short-selling process.

By Jim Cramer Oct 26, 2011 9:21AM

the streetHow can Netflix (NFLX) fall and fall and fall some more over the same sagging data? How can the company be worth a small fraction of what it was just a few months ago?


The answer lies in short sellers and the flawed process of betting against stocks.


When you buy a stock, it's pretty simple. You place an order, a seller is found, and you get your report. Usually there are so many sellers at once that unless the stock is incredibly thinly traded -- say, a couple thousand shares a day -- an order of any magnitude is pretty much handled in line.


But a short seller has a different set of rules. If you want to sell something, you have to own or borrow it first so that the buyer gets delivery of the stock. When you own it, of course, you sell your shares and the buyer gets them. But if you sell it without owning it, what does the buyer get? Does he get a notice saying, "Sorry, stock unavailable"?


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No, the buyer won't tolerate that. So the short seller has to borrow the shares, typically from what is known as the broker's electronic vault. Only after the shares have been located can the short seller go to work betting against the stock.


Now, there were always deep suspicions about how long Netflix could continue to grow. How many people want to get DVDs in the mail? How large is that audience? Aren't there plenty of alternatives, whether it be Blockbuster, or Coinstar (CSTR) or video on demand from your cable operator?


But the company, during the days when the distributors of films and television programs were hurting, managed to lock up a tremendous breadth of product that made Netflix a joy to be a part of.


When people thought the DVD market was getting saturated, Netflix introduced a streaming service that was wildly popular and answered the critics' worries about the next leg of growth after DVDs.


As the company grew, the number of people who thought the business would hit a wall increased almost by the day. The critics felt that either subscriber growth would peak or the cost of content would skyrocket as studios recognized that, while they needed the money Netflix offered, they could play hard to get now that times had improved. So the skeptics sought to short the stock with reckless abandon.


But the supply of stock outstanding needed to locate shares to sell short wasn't expanding at all. In fact, it was contracting because of Netflix's buyback.


So shorts kept shorting and trying to borrow stock and they couldn't locate it.


When you can't locate a stock, you are forced to cover your position, or buy back shares. When you saw the stock skyrocket from $50 to nearly $300, some of that demand was from natural buyers. But much more was from buyers who were forced to cover. In an amazing confluence, just at the height of when short sellers were being forced to cover like mad, Netflix committed its now legendary screw-up.


The long investors panicked, but more importantly the short sellers, who would normally cushion the blow with their buying, had been wiped out by the rise.


The result? No floor. None. Without growth, with a shrinking subscriber base and with no natural covering short sellers, what happened?

You got this astounding collapse from a level that it should never have been at. You want to know why Netflix soared? Blame the short-selling process. You want to know why it collapsed? Blame management, for certain. You want to know why it fell with such velocity? That's what happens when a stock gets squeezed up to the point that there's no one left to cover.


At the time of publication, Cramer had no position in any of the securities mentioned.


jim cramer
Jim Cramer
is a co-founder of TheStreet and contributes daily market commentary to the financial news network's sites. Follow his trades for his charitable trust.

Oct 26, 2011 11:40AM
from a CNBC article from july 2011.

"A lot of investors are worried customers may cancel their subscriptions due to the price hike, but Cramer isn’t too concerned. He has faith in Hastings and Netflix’s future prospects."

Fantastic advice we get.  Buy buy.  Oh wait, it crashed.  Ok, here's why it crashed......  
Oct 26, 2011 10:21AM
Cramer was recommending NFLX on his May 20th show with the stock trading at 245.00.
Oct 26, 2011 11:18AM

once again it's not the fundamentals,it's the short sellers fault

this guy knows nothing except his false self image



Oct 26, 2011 10:35AM
cnbc has very few serious stock and business shows. Fast,strategy (cancelled) etc are excellent resources. Squawk Box represents the worst as political hacks (kiernan,sorkin,cabrerra,kudlow) want to further their own agenda. cnbc should restructure their shows if they want to be something more than a shill for insiders. Buy American and support our Troops.
Oct 26, 2011 11:22AM
Netflix has become too greedy. I stopped using them and started using "TV Devo" for streaming TV and Movies. Also use Redbox for $1 per movie.
Oct 26, 2011 10:49AM

once again the expert looks at history and educates us about netflix

and since he is always looking back he is always right


why does cnbc need a disclaimer on the shyster but not the others on the program?

Oct 26, 2011 1:33PM
Don't forget the "They Know Nothing" rant.  Cramer's first allegiance is to the NYC investment banks.
Oct 26, 2011 6:57PM
Short selling can make a lot of money but you can also lose a lot too. It is kind of like gambling, you are risking money to make money. But if you do your research, you can make a lot of money. If you don't know what short selling is, this article gives a great explanation on it.
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