Why I'm Selling Netflix

Anyone currently holding or considering buying shares of DVD-rental leader Netflix.com (Nasdaq: NFLX  ) should remember these three words: margin of safety. As in, it's not there anymore. At roughly $24 each, shares of Netflix may be a lot of things, but they're not undervalued.

I should put my comments into perspective, since I've been an ardent supporter of the Motley Fool Stock Advisor selection. I've written about the company's moat, found its business superior to Blockbuster's (NYSE: BBI  ) service, and defended the company vigorously against charges that it had managed earnings. You'll notice from the articles that I've been a shareholder for a while, too. But I've also lamented the company's advertising pact with Wal-Mart (NYSE: WMT  ) and dismissed its fledging "Movies For Sale" section as inconsequential. (Fellow Fool Rick Munarriz disagreed on that last point.)

At anywhere under $14 per share, I'd say the stock is undervalued, given its whipsawing price and future potential to forever change the way we view movies. But while the company's founder and most insiders have to stay committed to this story and see how it ultimately plays out, as an open-market minority investor, I don't. Neither do you. So, after a 150% rise in under a year, I'm getting ready to take what a very euphoric Mr. Market has given me and cash out completely. Netflix, it's been a pleasure.

Why wouldn't I currently pay $1.3 billion dollars for Netflix? Aside from the hefty 30-times-2006-earnings price tag, monthly churn of long-term customers (one or more years) is still much too high. While management hasn't given us an exact number, during the latest conference call they estimated it to be around 2.5% per month -- which means that more than 30% of Netflix's long-term customers cancel their service in a given year. While around one-fifth of those jumping ship come back eventually, you're still left with a subscription business that roughly a quarter of customers in a given year decide they don't need after all. That's one leaky bucket, and compensating for that leak is going to get increasingly difficult as Netflix gets bigger. Sustaining annual earnings growth greater than 20% is going to be next to impossible. (I should add that I'm not alone; analyst Michael Pachter of Wedbush Morgan has been pointing this out for a while now).

Netflix is a great company. I admire Reed Hastings immensely, and I honestly think I'll be a Netflix subscriber for life. But a great company is not the same thing as a great investment opportunity. The time to make money on this stock was when no fewer than eight analysts downgraded it in one day, when it was scheduled to post negative earnings for the foreseeable future, when fellow Stock Advisor pick Amazon.com (Nasdaq: AMZN  ) looked ready to crash and take over its party, and when cash-on-book made up one-third of the company's market capitalization.

And that time has passed.

For more on the ongoing Netflix debate, have a look at yesterday's bare-knuckle brawl between Rich Smith and Rick Munarriz.

Add your own review of this take on our Netflix discussion board.

Seeking superstar stocks? Tom and David Gardner'sMotley Fool Stock Advisorcan help you queue up a portfolio of powerful picks. Sign up today for a free 30-day trial.

Fool contributor Marko Djuranovic still owns shares of Netflix, but not of any other company mentioned in this article. The Fool has a disclosure policy.


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