Netflix (Nasdaq: NFLX): Is Carl Icahn a Madman or Genius?

Netflix Inc. (Nasdaq: NFLX) shares rallied 11.4% in late trading on Wednesday to close at $79.24 following news that activist investor Carl Icahn made a big move on the stock.

Icahn took a nearly 10% stake in the company through shares and long-term, over-the-counter call options mostly purchased at prices below $60.

In afternoon trading on Thursday, Netflix shares were down slightly, trading just under $79.

That means that Icahn and his partners are sitting on gains of between 30% and 44% on Netflix shares and call options purchased between Sept. 4 and Oct. 25, according to Schedule 13D filed with the U.S. Securities and Exchange Commission (SEC) yesterday.

That alone should put Icahn firmly in the genius category.

What is Carl Icahn's motivation for acquiring his stake in Netflix?

"I believe that there is going to be great consolidation between Netflix and, everybody's read about it, Amazon or Microsoft or Verizon or Google, there are so many possible combinations," Icahn told Bloomberg TV.

The Value in Netflix (Nasdaq: NFLX)

A big question surrounding the stock is how much value exists in NFLX's subscriber base.

Netflix continues to lead its competitors in terms of subscribers by a wide margin. In fact, the number of domestic subscribers is at a new high, recovering from the debacle surrounding the separation and repricing of the company's DVD rental and Internet streaming services in 2011.

The company is aggressively expanding its services overseas, but the international business is still burdened with startup costs and remains unprofitable.

Netflix claims to have the largest video library of any Internet streaming company and has billions of dollars in long-term commitments to content providers. In addition to third-party content, NFLX is producing some original programming in an effort to become the "HBO of the Internet."

NFLX has also invested heavily in algorithms that suggest content to subscribers based upon past viewing habits. This technology may have value in other applications, such as marketing.

In Icahn's view, all of this makes Netflix attractive to other companies that want to be big players in streaming video over the Internet.

Netflix Stock Chart
(Nasdaq: NFLX)

Wall Street Balks as Icahn Buys Netflix

Yet most Wall Street analysts and talking heads are arguing that Icahn must be a madman for taking a stake in NFLX.

Needham & Co. analyst Charlie Wolf told Barron's, "What does Icahn see that we don't? ... [I]t looks unlikely that the company will generate more than nominal profits through 2014, if then."

Wolf continued, "Icahn may be interested in NFLX on the basis of last week's speculation that Microsoft may be interested in buying Netflix. Given what we see as Microsoft's weak acquisition history, this speculation may well have merit."

The curmudgeonly Wolf was not to be outdone by Wedbush Securities analyst Michael Pachter, who told Bloomberg Businessweek, "Icahn is clearly misguided. Unfortunately, he's convinced that he's right, and he's going to try to impress that on [Netflix CEO] Reed Hastings."

Forbes contributor, Panos Mourdoukoutas, who disclosed that he is short NFLX through an options position, wrote, "I still believe that Netflix's business model isn't sustainable...While I do respect the instinct of Carl Icahn, I do believe he is wrong on Netflix, the company has no sustainable competitive advantage; and wishing him good luck in selling his stake in the company at a market premium."

In fact, looking through the commentary on Icahn's interest in Netflix, it was hard to find anyone who had anything positive to say about it.

Which brings us to another point. The market is short NFLX in a big way.

As of Oct. 15, 2012, there were 16.2 million shares of NFLX short, equal to 29.1% of shares outstanding. That's more than two days of trading at current elevated volume.

In addition, there are another 26.7 million shares worth of out-of-the-money put options with strike prices between $60 and $77.50.

There is only one way to close a short position in a stock-you have to buy it back. What we have here is an Icahn-inspired short squeeze in Netflix. NFLX shorts are scrambling to cover as quickly as possible, putting more buying pressure on the Netflix share price.

How far can the short squeeze run?

It looks like NFLX will have to take a breather around the 200-day simple moving average, which currently stands at $82.35. With Icahn in the game, NFLX could break above the 200-day simple moving average but we are likely to see consolidation around that level first, as the current round of short covering subsides.

Do you like tech stock analysis? Then check out this latest report from our tech specialist Michael A. Robinson.

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