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With a current market capitalization in excess of $9 billion, Netflix (Nasdaq: NFLX  ) is stepping into the big leagues. All revolutionary companies must make this transition before becoming a true Rule Maker. Unfortunately, the transitionary period is dangerous ground. 

Many revolutionary companies (think AOL, Yahoo!, and that pre-Google (Nasdaq: GOOG  ) search company Inktomi) all passed through here. While Netflix pioneered the DVD-by-mail market and has become its undisputed leader, it's making a difficult business model switch to online streaming. From a valuation perspective, Netflix has certainly grown up, but investors should be aware that Netflix's future dominance is far from certain. Here are three reasons for current investors to be concerned.

1. Growth doesn't always equal profit
By some respects, Netflix is firing on all cylinders. It ended the third quarter with 16,933,000 total subscribers, tallying its fourth consecutive quarter of more than 1 million subscriber additions. CEO Reed Hastings proclaimed, "By every measure, we are now primarily a streaming company that also offers DVD by mail."

Unfortunately, growth in the bottom line isn't keeping pace with the growth in subscribers. Assuming no stock buybacks, which I'll talk about later, diluted EPS in Q3 2010 would have been $0.655. That's about 26% higher than Q3 2009 diluted EPS of $0.52, but nowhere close to the 52% growth in subscribers. Net income per subscriber actually declined 17% in the past year, from $2.71 in Q3 2009 to $2.24 in Q3 2010. This rapid decline in margins and revenue per subscriber doesn't seem consistent with other dominant Rule Makers like Google, Microsoft (Nasdaq: MSFT  ) , or eBay (Nasdaq: EBAY  ) .

2. Is content or distribution king?
Netflix is rushing to build out its library of online streaming content, but that doesn't come cheap. This year, it signed a deal with Epix that is rumored to cost $1 billion over five years. That's greater than all of its operating income in 2009. Isn't the dominant company supposed be able to dictate favorable terms? This makes Netflix seem less like Wal-Mart (NYSE: WMT  ) and more like Sirius XM (Nasdaq: SIRI  ) . Remember when Sirius paid hundreds of millions to Howard Stern as it sought to build out its content offerings?

3. Manage the business, not the stock
Reed Hastings finds himself in a difficult position right now. He's built a wonderful business that is transitioning from DVD by mail to online streaming. Unfortunately, it has to pay to support both distribution networks, and to build out a costly library of streaming content at the same time. All this is happening while most of its new subscribers are paying a lot less than DVD-by-mail customers (usually opting for the one-disc-per-month option for $8.99 per month).

One way to prop up earnings is to buy back stock. In the past year, the share price has increased from $57 to $169. Despite the rise in price, Netflix has continued to buy back stock, spending $289 million on stock repurchases in the last four quarters. This helped increase diluted EPS in Q3 by about $0.05, from $0.65 to $0.70.

I'm all for share repurchases, so long as the company has excess capital and is purchasing shares at a discount to its value. In Q3 2010, Netflix actually accelerated its stock purchases, spending $57 million versus $45 million in Q2 2010.

The bottom line
Netflix is a very good company, and many Fools will disagree with my conclusions. (Netflix remains a Core Stock in Motley Fool Stock Advisor, for example.)

But even great companies can be bad investments when purchased at the wrong price. Right now, it appears as if investors believe Netflix has won the battle, and that its growth will continue unabated. But competition, even inept competition, can throw a wrench in the best-laid growth plans.

Furthermore, growth at the cost of decreasing margins and profitability per subscriber is not a welcome sight. Current Netflix investors might take a cue from company insiders. While Netflix the company continues to buy back stock, insiders have diversified their wealth, having sold some $199 million in stock over the past year. There have been no reported insider purchases over the same time frame.

Want to follow the Netflix story? Add it to your watchlist to stay updated.

Google, Microsoft, and Wal-Mart are Motley Fool Inside Value choices. Google is a Motley Fool Rule Breakers selection. eBay and Netflix are Motley Fool Stock Advisor picks. Wal-Mart is a Motley Fool Global Gains selection. Motley Fool Options has recommended a bull call spread position on eBay and a diagonal call position on Microsoft. The Fool owns shares of Google, Microsoft, and Wal-Mart Stores.

Buck Hartzell loves Netflix the service. He owns shares of Microsoft and eBay, but holds no financial position in any other companies mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (11) | Recommend This Article (20)

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 November 12, 2010, at 12:56 PM, ItAintCool wrote:

    "Sirius XM (Nasdaq: SIRI). Remember when Sirius paid hundreds of millions to Howard Stern as it sought to build out its content offerings?"

    Yes, I do, it was 6 years ago and Sirius had about 800,000 subscribers at the time and was considered a distant second from XM Sat. Today it has about 20 million subscribers, after it forced a merger with it's only competitor (which at the time had more subscribers) making it a virtual monopoly. I'd call it money well spent.

  • Report this Comment On November 12, 2010, at 3:12 PM, TMFJoeInvestor wrote:

    Sirius is totally a monopoly, save for people being able to listen to CD's, MP3's, podcasts, audio books, and Pandora. Oh, and the free terrestrial radio available virtually everywhere. But, yeah, other than that, they've pretty much got a monopoly.

  • Report this Comment On November 12, 2010, at 3:48 PM, TMFSoccer wrote:

    I was fumbling through my Netflix Xbox experience last night. The site simply hasn't caught up to the new ways people watch and search. I think I wasted an hour trying to find some decent movies to watch instantly. I do worry that this company is making a major strategy shift without complete alignment. It is hard to please all the customers on all the different platforms as opposed to dominating one.

  • Report this Comment On November 12, 2010, at 4:41 PM, TMFJoeInvestor wrote:

    In hindsight, while I stand by my general point, my previous comment was more than a couple of notches above necessary on the snark scale. Apologies, ItAintCool.

  • Report this Comment On November 12, 2010, at 5:31 PM, ItAintCool wrote:

    Apology accepted TMFJoeInvestor.

    However, I did say "virtual" monopoly, as in the fact there are no other Sat Radio companies in competition with Sirius-XM. Even in Sat TV, DirecTV has to compete with Dish Network. And there are plenty of other Sat TV companies around the world. But Sirius-XM remains the sole Sat Radio provider in the world.

    Now the points you made were the same arguments Sirius & XM used to convince the government to approve the merger. But if you also remember it was the terrestrial radio owners and operators (and the NAB) who fought tooth and nail against the merger, saying that it was creating a "monopoly". So many of the "competitors" you cite are the ones who did claim it was a monopoly in the first place. As for the other competitors mentioned, Pandora will never be a legitimate or serious competitor unless "net neutrality" is brought back, which is unlikely with the current congress. And to be quite honest, IMHO Pandora current business model cannot last. Its paid subscriber numbers are less than 1% of what it's free subscriptions are (and the free subscriptions are in dispute because anybody who downloads the app is considered a "subscriber" even if they never listen to more than one time. I think it will have to be bought out by one of the cell-phone internet service providers or a major media provider to survive in the long-term.

    Lastly; the main point of my post was not that Sirius XM is a "virtual monopoly", but that the author implied that Sirius may have made a bad judgment on their part hiring Stern because they were in a weak position. Forcing them to agree to his high-price ticket. However, the truth is that hiring Stern was a major game-changer for the company. Sirius was in a distant 2nd place compared to XM pre-Stern. His hiring had turned the company around in ways that put the company in the limelight and brought to them a huge amount of new subscribers (since the actual number of subscribers are disputed, let's just say multi-millions). Certainly enough subscribers to pay for his hiring (which would be at least 1 million). In the end it allowed them to catch up to XM and forcing the merger, with their company being in the dominant position for the merger. I would be not out of line to say, that if XM had hired Howard first, there would not be a Sirius today. XM would not have had to even push for a merger as their competitor would have probably folded due to lack of subscribers.

  • Report this Comment On November 12, 2010, at 6:00 PM, TMFBuck wrote:

    Hi ItAintCool,

    Thanks for the information on Sirius. My point in including them was slightly different than what you stated. My point is simply that the value being created by the distribution platform went to the content creators. In Sirius' case, that's Howard Stern. They may have beat XM but who really cares? As an investor you're looking for companies that create value for shareholders. Sirius may well turn out to be a wonderful investment, I haven't researched them for long at all. From a quick glance, it looks like a company who has lost money over the last five years and heaped on a bunch of debt on their balance sheet. and the stock sits at $1.40. So, lots of happy customers doesn't necessarily equal a good or even profitable business. In the long run, you need that to create value for shareholders.

    Getting back to Netflix, it's not clear who is going to capture the value of their growing streaming service. If you're paying out more than 100% of your operating income to license some content from a small studio, that doesn't bode well for your future. What happens when they need to resign Starz?

    It's not just about growth. It's not just about making your customers happy. Ultimately, you need to earn a suitable return on the capital you deploy. The amount they need to deploy in the future for content is up in the air. The millions they are using to buy back stock appear questionable to me. Of course, time will tell how it all plays out.

  • Report this Comment On November 12, 2010, at 6:56 PM, ItAintCool wrote:

    "As an investor you're looking for companies that create value for shareholders. Sirius may well turn out to be a wonderful investment, I haven't researched them for long at all. From a quick glance, it looks like a company who has lost money over the last five years and heaped on a bunch of debt on their balance sheet. and the stock sits at $1.40. So, lots of happy customers doesn't necessarily equal a good or even profitable business. In the long run, you need that to create value for shareholders."

    Agreed, and my apologies if I misconstrued what you meant. But what you say about value for shareholders also depends when you became a shareholder. If it was 5 years ago, when it was in the $6 range, you may be unhappy now. Unless of course, you either sold off before the free-fall, or continued to buy in on the way down to its all-time-low of .05, which then significantly brings down the dollar cost averaging of the investor, as it did for me. I bought in at $5.90, sold about 1/2 when it went to $3.00 and then bought in on the way down and a ton when it hit the bottom. My dollar cost averaging is now at .50. I have made back my losses from selling the first 1/2 of my shares @ 3.00. I am a happy investor.

    Now on the other hand, if you were a SIRI Investor over the last 2 years, chances are you would be an extremely happy shareholder who has seen value in the company. The return on your investment could have been up to 3,000% (even a 50% return if you had bought in 10 weeks ago). Not many stocks can give you that kind return over such a short period of time. Once Liberty Capital backed the company from the verge of BK the stock has been on the way up. Why? Many (like your fellow MF Rick Murraniz) would say the fundamentals are quite good. It has a high level of subscribers, which are continually increasing, low churn and it is now generating free cash flow. It has even made a small profit over the last year.

    Now not every company to generate profit right from the get-go, but Siri's 5 years of losing money has given it a huge NOL tax write off as its profits to continue to grow. That is another aspect to it's value.

    Nay-sayers with cite it's debt load or dilution of shares. But the company has already done wonders to pay-down existing debt and refinance other debt at lower interest rates. Others who say that Sat Radio is remaining stagnant in the face of emerging technologies, like internet radio, are ignoring the already announced and soon-to-be implemented Sat Radio 2.0 (look it up). And besides, as I cited before, Internet Radio in moving vehicles and smart phones will become dependent on "net neutrality", which doesn't seem to be happening at this point.

  • Report this Comment On November 12, 2010, at 7:58 PM, XMFConnor wrote:

    Great article. I especially like the point about insiders selling yet the company buying back shares aggressively. I bought at $40, sold at $80, and have painfully watched it double again from my selling price, but I just can't be comfortable with its current valuation.

  • Report this Comment On November 12, 2010, at 8:57 PM, doubting wrote:

    The worst mistake one can make is to talk about sirius and xm versus sirus xm. The companies merged in the summer of 2008 and it is time to see them as one single company with virtually no competition. This is critically important if you want to make any analysis or judgements. Both companies have planted seeds of success and the single company sirius xm has just started harvesting amazing results. It is obvious to anyone who has followed the company and has done the RESEARCH that it is already doing well. But this is just a tip of the iceberg of siri success. Even very conservative analysts who have been for years negative toward siri started acknowledgeing that, barring some unexpected economy failure, the company will be a cash cow producing over $1B cash as early as 2013, and in my opinion even sooner. Mergers are dififcult to manage and streamline. The company is blessed to have Karmazin and his team. Another two or three years and we will be dealing with a truly single company with a single service and tons of synergies to relaize. I can only think of apple, google and microsoft when I look for siri comparisons. I have been very consistent in my opinion for years even at the worst times for siri claiming that it will do well. Now the facts are supporting my judgements, and only fools or bashers can ignore facts. Even morning stars, zacks, moritzes and other geniuses shut up because they started getting that it may feel nasty when you piss in the wind. Siri is a phenomenal business with a fantastically smart and I would say shrewd business model. Its stock will be in tens of dollars in the next 5 to10 years no matter what you say becaue it actually does not matter what you say. What really matters is the results the company is delivering. Those who have patience and time stand to make very serious money on the order of ten to one hundred times their investment depending on when they got into this game. This is of course if liberty does not acquire them at an early stage. This is the only thing that I would be really afraid of.

  • Report this Comment On November 15, 2010, at 9:33 AM, Brent2223 wrote:

    Due to the vastly differing opinions presented by MF on SIRI, I think it would be helpful for authors to be more explict on the point they are trying to make. I took the SIRI reference in the article as a back handed jab. I'm glad the author clarified in the comments, but probably could have been clearer in the article.

  • Report this Comment On November 15, 2010, at 9:58 AM, TMFBuck wrote:

    Hi Brent2223,

    TMF embraces and likely will have differing opinions on probably all stocks. We think it's healthy to seek out opinions that are contrary to our own. While we are far from perfect, we try hard to avoid group think on any position.

    As far as SIRI goes, I really don't have a strong opinion on them as an investment. The question of who is king the content creator or the distributor probably applies to them as well. The Howard Stern deal told me that they needed Howard more than he needed them. Of course I could be wrong. Based on the terms of the recent Netflix deal it appears their costs for streaming content will be much larger than I expected.

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