10 Core Stocks for Your Portfolio: Netflix

This week and last, we're presenting 10 core stock ideas -- stocks our writers believe can serve as the foundation for a long-term-focused portfolio.

Company

Netflix (Nasdaq: NFLX  )

Operations

Netflix turned the movie rental industry upside down with its rentals-by-mail model, and it is doing it again with streaming digital movies.

Recent Price

$140.50

Market Cap

$7.4 billion

Trailing P/E Ratio

57.1

Return on Equity, Last 12 Months

54.60%

Source: Capital IQ, a division of Standard & Poor's.

The business
If you don't know what Netflix is, I can tell a few things about you:

  • You don't watch a whole lot of movies.
  • You don't even watch TV or surf the Internet, or else you would not have been able to avoid the torrent of brand advertising for the innovative movie rental service.
  • You may live under a large rock somewhere in the Utah salt flats.

In the 2000s, Netflix brought the novel idea of shipping movie rentals by mail into a fat and complacent movie rental industry -- and turned the whole industry inside out. Now former champ Blockbuster teeters on the very brink of bankruptcy and irrelevance, and mom-and-pop video stores are about as common as yeti sightings. And that's just the beginning.

For an encore, Netflix was first to market with a digital streaming service that delivers movies to computers, Blu-ray boxes, modern TV sets, and even mobile gadgets, all for the low, low price of free with any full-priced DVD-mailing subscription. This subscription model is radically different from the pay-per-rental services you'll find from Apple (Nasdaq: AAPL  ) and Amazon.com (Nasdaq: AMZN  ) , and consumers appear to like it a whole lot better. The subscriber growth curve tells that tale better than words.

With more than 15 million paying subscribers, Netflix is already larger than Time Warner Cable (NYSE: TWC  ) , which is the second-largest cable TV network by number of subscribers, and likely to catch No. 1 Comcast (Nasdaq: CMCSA  ) in the next couple of years.

Why it's a core stock
The massive subscriber base is the result of a deliberate strategy to grow customer counts above all else. By pumping any extra cash into more advertising and better digital streaming licenses, growth is nearly guaranteed while earnings and cash flows end up looking small.

But the day will come when there's no need to push that hard for new subscribers anymore -- the customer base will be big enough to move into the next phase. Turn off that investment faucet and the cash will start collecting very quickly in Netflix's coffers. What now looks like an expensive stock will immediately become a bargain when measured against the new economics. When that happens, you don't want to sit on the sidelines. And afterward, you will own an established leader in a whole new era of entertainment history -- and business.

There is also a good chance that a competitor will buy Netflix wholesale before that transformation happens, because we investors are not the only ones who see what's happening. Apple and Amazon are often mentioned as would-be Netflix owners, and I wouldn't count Google (Nasdaq: GOOG  ) or Comcast out of the game, either. Anybody with a fat wallet and serious ambitions in digital entertainment would do well to place a bid, at the very least.

Risks
Just as Netflix overthrew the old order, the new one is not immune to competition. You will often hear Coinstar (Nasdaq: CSTR  ) and its Redbox movie rental vending machines mentioned as a serious threat, because low-cost access to hot new releases at the nearest strip mall can trump the higher convenience but less up-to-the-minute collection of Netflix streams.

Likewise, the horde of digital rivals might figure out how to make their rental services stand up to the Netflix challenge eventually, and nobody knows what wizardry could be brewing in Berkeley garages and MIT dorm rooms.

Netflix defends against all of these threats by focusing on doing what it does best: movie rentals by subscription, delivered in the most convenient format the studios will allow.

In sum
This stock has been on an absolute rampage for a while, and shareholders have tripled their money in the last year alone. Meanwhile, the company is expanding its streaming library by investing almost every spare dime in new licenses. That combination makes the stock look tremendously expensive by any metric -- but then you're assuming that the train will keep on rolling down the exact same tracks until the end of time. As we've already seen, that's not in the cards.

You need a rather long investing timeline to hunker down with Netflix, because the switch to cash-generating digital dominance could still be years away. But when it happens, you definitely want to own this stock.

Fool contributor Anders Bylund holds no position in any of the companies discussed here. Google is a Motley Fool Inside Value recommendation. Google is a Motley Fool Rule Breakers pick. Apple, Amazon.com, and Netflix are Motley Fool Stock Advisor recommendations. The Fool owns shares of Google. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. You can check out Anders' holdings and a concise bio if you like, and The Motley Fool is investors writing for investors.


Read/Post Comments (4) | Recommend This Article (30)

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 September 20, 2010, at 11:09 AM, northhills24 wrote:

    THis is 7 >> what are the other 3??

  • Report this Comment On September 20, 2010, at 12:35 PM, TMFZahrim wrote:

    Wait and see, northhills24 -- they're coming up in the next three days!

    Anders

  • Report this Comment On September 20, 2010, at 1:43 PM, emptygestures wrote:

    I wouldn't touch NFLX until after their next earnings report. If it's another revenue miss then kiss these $140 levels goodbye.

    Their streaming doesn't even have movies released in the past year.. It's all old TV shows and movies from the 90s and 80s.

  • Report this Comment On September 20, 2010, at 6:35 PM, mattack2 wrote:

    emptygestures.. I don't know where you're looking.

    On the first page of my results, I see

    Aeon Flux -- 2005

    Surrogates -- 2009

    (and uggh)

    Paul Blart -- 2009

    G.I. Joe: The Rise of Cobra -- 2009

    (I still prefer the DVDs due to extra features, but those are recent streaming things.)

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