Throw This Stock Away

I've been tossing out stocks every week this summer. Portfolios can always use a little pruning, so why wait for spring cleaning?

I'm doing more than just aiming for the trash can, though. I always offer up three worthy substitutes to replace the stock that I've soured on.

This week, I've decided to do something a little different. I'm going with a stock that I own. Yes, I have actually been a shareholder of this company since shortly after its 2002 IPO, but I believe that playing devil's advocate is a healthy thing to do with your investments. Since no stock is ever perfect, let's see whether I can poke any holes in one of my own longtime holdings.

So, who gets thrown out this week? Come on down, Netflix (Nasdaq: NFLX  ) .

The typo so nice, they had to bungle it twice
Until last year, there wasn't a whole lot of "net" and even less "flix" in the company's model. Netflix has always been cozy with the Internet as a slick interface to queue up flicks and serve up recommendations, but it is -- in its purest form -- a DVD rental mail-order service.

This setup changed, of course, when the company began rolling out its Watch Instantly service, through which subscribers could stream select titles through their PCs at no additional cost. The service was slow to take off, but it's popular now that Netflix is using everything from Roku boxes to LG electronics to Microsoft's (Nasdaq: MSFT  ) Xbox 360s to deliver films directly into living rooms.

For now, at least, the library is limited to mostly indie films and obscure older titles, because major studios would never devalue their new releases without hefty revenue-sharing royalties in return. In fact, just 10% of the company's titles are available for streaming. In other words, the Netflix service can't really compete with the premium digital alternatives or your cable provider's video-on-demand offerings. You can rest easy, Comcast (Nasdaq: CMCSA  ) .

Netflix also absorbs the hit on the chunky bandwidth. The company views it as a loss leader. But that isn't the only reason margins will be challenged in the future. Postal rates keep climbing, and the soft economy is keeping penny-pinching consumers at home. Yes, that's good for subscriber retention, but homebodies will rent more DVDs in any given month. And more orders will cost Netflix more in postage and in revenue-sharing with the studios.

Can Netflix rise above that problem? Last week's quarterly report was pretty telling. The number of subscribers rose by 25%, but revenue climbed by just 11% and net income inched only 4% higher. A lot of the deterioration on the way down was the result of a price cut last year to keep Blockbuster (NYSE: BBI  ) away. That strategy worked, but now consumers may not be receptive to a price increase.  

Netflix is looking to close out the year with as many as 9.7 million members and to come in squarely profitable, with between $1.19 and $1.31 a share in earnings. However, the future will be challenging to both the optical disc as a medium and the company's ability to compete in the cutthroat realm of digital delivery.

Good news
As I do every week, I don't talk down a stock unless I have three alternatives that I believe will outperform the company getting the heave-ho. Let's go over the three fill-ins.

  • Apple (Nasdaq: AAPL  ) : Apple TV was a rare miss in the Cupertino company's product line, but it's certain that Apple will still play a major role in the digital delivery of celluloid. The company's iTunes store is a leader in selling video downloads, and the convergence of computing and home theater won't be complete until Apple has a say in the future. 
  • Bidz.com (Nasdaq: BIDZ  ) : The online jewelry auctioneer has little in common with Netflix, but it makes the cut this week because of the similar way it butchers its name with a deliberate hipster typo. Bidz is growing a lot more rapidly than Netflix is, and it's selling at just 17-18 times this year's recently reaffirmed earnings guidance. Netflix is priced at a more expensive 22-24 times this year's profit target.
  • Amazon.com (Nasdaq: AMZN  ) : Amazon sells a ton of DVDs in its online store, but it's now a major seller in digital downloads, rentals, and streams of films and television shows. Amazon shares aren't cheap, but it has earned its premium with accelerating growth and promising initiatives to replace all three of its original media categories -- DVDs, CDs, and books -- with higher-margin digital alternatives. 

Invest carefully, and don't forget to separate your trashed stocks from the ones that can be recycled.

Other headlines out of the weekly garbage:

Do you like Rick's substitutions? Would you rather stick it out with Netflix? Are there other stocks Rick should look at in future editions of this column? Let him have it in the comment box below.

Microsoft is a Motley Fool Inside Value recommendation. Netflix, Amazon.com, and Apple are Stock Advisor recommendations. Try any of our Foolish newsletter services free for 30 days.

Longtime Fool contributor Rick Munarriz has been a Netflix shareholder -- and subscriber -- since 2002. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 29, 2008, at 3:37 PM, slade15342 wrote:

    Odd that on the day you throw it out it goes up almost 8%. Isn't this investing game fun? I like AMZN for 2-4 years, but I can't see this sector accelerating until everything else is firmly on the ground. Like real estate, banking, etc.

    I back this up by saying consumer spending is driven by free money, which means that they are able to pay for their staples like gas, food, housing. Amazon will come along when the rest of the stars align.

    Cheers, good luck

    http://www.thegearedinvestor.com

  • Report this Comment On July 29, 2008, at 8:00 PM, JPDemers wrote:

    So long as the studios remain in obscenely-greedy mode, which has been reliably the case for about 80 years, nobody is going to be delivering much in the way of digital downloads, unless it's at $5 or more per movie.

    For that reason, Netflix doesn't yet have to worry about digital competition, and they're putting themselves in a good position to deliver if and when the studios wise up. If there's a gizmo that has digital storage and plugs into your TV set, NFLX seems to be building a delivery platform into it -- an excellent strategy for avoiding the "I have enough damned boxes" resistance that Apple has run into. Apple may eventually figure out an elegant one-box solution (a cable tuner with an internal hard disk, cable modem, and wireless router -- are you listening, Steve?), but until then there is no competition for the hearts, minds, and 50-inch screens of America's couch potatoes.

    They will probably have to raise prices to cover postage and increased volume per subscriber, but I can't see the customers going into revolt over it. (Perhaps they'll add another subscription tier to better align pricing with customers' usage.) And as far as I know, there's room to expand into Europe and Asia.

    Still solid, still growing, and still a hold, IMHO.

  • Report this Comment On July 30, 2008, at 3:05 AM, videophool wrote:

    I find it curious to put a sell on NFLX at $28. Why was it not a sell 3 months ago at $40? There has been no unexpected change in NFLX performance nor any significant change in the competitive landscape.

    As far as APPL this is an old story. Ever since rumors of APPL renting videos leaked, pundits have been writing obits for NFLX. Nobody seems to understand that the current APPL model is flawed. Buy a $300 Apple TV, and pay $4 to rent a movie and you must watch it in 24 hours (can not split between 2 nights). For the cost of 8 movies a month with APPL, you could have a premium Netflix account, and with the extra cash, pay your broadband bill, buy a ROKU and an xBox (paid over a few months). APPL's movie story is simply too expensive to have mass appeal.

    One more observation. The short interest on NFLX is currently 40% of float. This makes no sense for a company with such strong fundamentals. It is purely speculative.

    but what do I know, I am a phool

  • Report this Comment On July 30, 2008, at 3:25 AM, djjoeyd1167 wrote:

    He is an ass!!!!! bbi is going to be cutting into there profits! Wait and see!

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