Why I'm Not Selling Netflix

When a stock is out of favor -- as Netflix (Nasdaq: NFLX  ) was back in March, when it bottomed out at $8.91 -- bulls are often hard to come by. Misery loves company -- just not miserable companies. The DVD rental pioneer was against the ropes then. Amazon.com (Nasdaq: AMZN  ) was threatening to enter the market. Blockbuster (NYSE: BBI  ) was devaluing the niche by practically giving away its online offering. Marketwatch's critical Herb Greenberg, a stock cynic who was spot-on in bashing Krispy Kreme (NYSE: KKD  ) last year, was digging into Netflix.

I know there were still some Netflix bulls out there. The stock made it to the final round of our Stock Madness 2005 competition. However, in terms of written analytical content, it seemed as if it was just Marko Djuranovic and I discussing the company in favorable terms.

This isn't an "I told you so" back-patter, because I've been dead wrong before. However, watching Netflix shares triple off their springtime lows has certainly felt pretty good. That's why I was taken aback two months ago when Marko wrote that he was looking to sell his shares in Netflix.

Not me. Not now.

Marko argues that he is still a fan of the service but would prefer to nibble at the stock if it dropped back to the low teens. I can sympathize with valuation issues. Ever since I joined the Motley Fool Rule Breakers analytical team last year, my biggest challenge in embracing David Gardner's ultimate growth investing philosophy was adjusting my approach to valuation. David has no problem in buying high and selling higher. Many of his greatest-performing stocks were companies with high relative-strength values when he first bought in.

Looking at my portfolio over the years, I see that I bought into some great growth stocks like Marvel (NYSE: MVL  ) and Electronic Arts (Nasdaq: ERTS  ) , only to sell way too soon. I got nervous. I grew impatient. I mistook a hiccup for a head wound.

I'm not going to make the same mistake with Netflix. This doesn't mean that I'm going to hold my shares with eyes shut and fists clenched. If I see the company's dynamics deteriorate to the point where it has been damaged irreparably, I'll be quick to bolt. I just know that it won't be based on some line in the valuation sand.

For starters, where does an investor draw that line? Analysts tracking Netflix are all over the map with this one. Over the past month, five analysts have raised next year's profit targets, while another two have lowered their projections. Yes, one can see that the average stood at $0.73 a share three months ago and stands at $0.80 today, but the averages can be deceptive. Means can be mean. That's because the dozen professional earnings-model builders who get paid to nail what Netflix will do expect the company to earn as little as $0.46 per share to as much as $1.17 a share.

Can earnings come in at the low end? Sure. What if Blockbuster decides to go down in a blaze of glory with the mother of all price wars? What if Netflix isn't able to grow its margins as quickly with its low membership prices? Tax concerns have also been raised. Then again, earnings can also come in at the high end. The company's advertising initiatives may pay off. New revenue streams may open up.

The stock has risen another 20% since Marko's valuation critique, but there's the rub. Based on the wide range of analytical forecasts, Netflix can be trading for as little as 24 times next year's earnings or as much as 62. Back out the company's $181.9 million cash balance to base your valuation on enterprise value, and the multiples are still wide apart, just 10% lower.

Netflix has already provided the market with guidance for 2006. It expects to close the year with at least 5.65 million subscribers, a dramatic improvement from the 3.6 million it has at the moment and the 4 million it is pegging to land by the end of next month. With 66 million shares outstanding, its pre-tax profits should come in between $0.76 to $0.91 a share. So why is Wall Street all over the map? Because it can? Because it can't?

The market can read. The market can write. Why can't it get Reed right? By Reed, I mean CEO Reed Hastings. Earlier this year, I asked him why Netflix wasn't offering video game rentals. He had the logical concerns. Games are costly. They get dated quickly. Yet when I pressed him into a possible scenario that Blockbuster -- or Amazon -- would launch a video game rental service first, he almost changed his tune. Well, at least he wouldn't categorically deny he'd follow suit.

That brought back to mind how Reed turned the company's pricing model on a dime, sharply reducing its subscription fee for its most popular unlimited DVD plan by $4 a month, just on the very whiff of Amazon as a potential entrant.

It's for that reason alone that I would be hesitant to nail the company to a stagnant model or price targets carved in stone. Reed expects to have 20 million subscribers in the next five to seven years. It's the exact same timeline and milestone that $6 billion XM Satellite Radio (Nasdaq: XMSR  ) has set for itself. As ambitious as that target may seem, Netflix has been pretty good about nailing, and surpassing, its marks.

Why sell now when Netflix may command an audience that is five times greater come 2010? Why sell now based on next year's bottom-line targets, when so much can go right -- or wrong.

Netflix has an amazing distribution center in place. It has perpetual contact with 3.6 million early adopters with disposable income to burn. Will we be swapping CDs, software, audio books, video games and digital books through Netflix in the future? Will marketers be filling the company's coffers by piggybacking their advertising efforts as a way to reach the company's affluent audience?

Man, the future is so bright for Netflix, and a dozen MBAs can't even come within spitting distance of one another to tell me what the company will earn tomorrow. I'm supposed to sell my shares -- and relinquish my gut instinct that Netflix will have a future far greater than most can fathom -- based on that?

Not me. Not now.

Why me? Why now?

Netflix has been selected three different times over the past three years as aStock Advisorrecommendationand has trounced the market all three times. Amazon.com, Krispy Kreme, Marvel, and Electronic Arts have also been Stock Advisor picks. Learn more by taking a free30-day trial subscription.

Longtime Fool contributor Rick Munarriz has been a Netflix subscriber -- and investor -- since 2002.The Fool has a disclosure policy. He is also part of theRule Breakersnewsletter research team, seeking out tomorrow's ultimate growth stocks a day early.


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