Blame Yourself, Not Reed Hastings, for Netflix's Woes

Time for some tough love, tiger. 

If you bought Netflix (Nasdaq: NFLX  ) stock last year at $300, blame yourself, not Reed Hastings.

You willfully paid 137 times trailing free cash flow (and 100 times earnings) for a business. No one made you do that. Reed Hastings certainly didn't. That was an unforced error, to borrow a phrase from Warren Buffett and the tennis court. 

With that kind of multiple, you're just begging for the ghost of Ben Graham to come and haunt your portfolio (I hear he's more of a morning poltergeist). There is no margin of safety at that price tag: If the future ain't as rosy as you predict, or your fellow investors simply lose faith -- as was the case with Netflix -- you risk a permanent loss of capital. Netflix certainly hasn't been unique in this regard lately: OpenTable, Green Mountain Coffee Roasters, and Tempur-Pedic have all suffered at the hands of overvaluation.

And who can forget the dot-com bubble? Oh, yeah, that would be the expert Wall Street analysts who pumped these babies to the moon.

It's worth noting that if you didn't pay an insane multiple for Netflix, then chances are you're sitting pretty even at $85 a share. The lesson here is that valuation can never be ignored wholesale. I'm looking at you, Amazon.com (Nasdaq: AMZN  ) investors. 

Reed Hastings' fault?
It's the job of the CEO to grow the fundamentals; it's the job of Wall Street and investors to price them. The failure here was with the latter group, not the former. Reed Hastings didn't mark the stock up to 100 times earnings; euphoric investors did. 

What Hastings is responsible for is Netflix's operating performance, and that has been absolutely terrific. 

Revenue has grown by 26% per year, on average, over the past five years. The story is the same for EPS (at 42%) and net income (at 36%). Return on invested capital has consistently been in the 15% to 30% range. That's even better than Amazon in all respects besides revenue growth. 

As for investors, Netflix's stock is still up more than 320% since this time in 2007. That's light-years better than the S&P 500, and it's superior even to Amazon's amazing 190% blitz. 

So if the stock hadn't made a brief detour to $300 but instead had a smooth ride $85, no one would be complaining about performance and Hastings would still be praised as a genius. Think about that. It hardly seems fair to judge Hastings differently for arriving at the same destination.

But if Wall Street and the media insist on doing so, then they should actually be praising Hastings. That's because his stock generously offered many years of future earnings and business returns -- in advance! -- back in July 2011. Pity, then, that more analysts and investors didn't recognize the "offer."

And the much-ballyhooed price increase -- the straw that broke the overvalued camel's back -- has turned out to be much ado about nothing. The company has more subscribers now that than it did before the price increase. Most any business that raised prices by 60% would go belly-up, but not Reed Hastings' Netflix. (Yes, that no doubt hurt its subscriber growth rate, but things appear to have normalized.)

Netflix has serious challenges in its future, such as contract negotiations with powerful studios, but it's clear that Hastings' leadership isn't one of them. To get the scoop on one company that could potentially dethrone Netflix in streaming -- that being Apple -- check out the Fool's new premium research report on the iEverything powerhouse.

Fool contributor Chris Baines is a value investor. Follow him on Twitter, where he goes by @askchrisbainesChris' stock picks and pans have outperformed 96% of players on CAPS. He owns no shares of the companies mentioned. The Motley Fool owns shares of OpenTable, Tempur-Pedic, Amazon.com, Netflix, Apple, and Green Mountain Coffee Roasters. Motley Fool newsletter services have recommended buying shares of Netflix, OpenTable, Apple, Amazon.com, and Green Mountain Coffee Roasters, creating a bull call spread position in Apple, and creating a lurking gator position in Green Mountain Coffee Roasters. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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 (6) | Recommend This Article (2)

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 16, 2012, at 10:14 PM, SuntanIronMan wrote:

    So when Reed Hastings (and the board) was purchasing shares (buybacks) of his own company all the way up to that 137 times trailing earnings... can we blame him then?

    'We' as in the global-we. I have nothing to personally blame Mr. Hastings for since I didn't invest in Netflix when it was valued that high.

  • Report this Comment On July 16, 2012, at 10:18 PM, SuntanIronMan wrote:

    Opps. Meant to write: 137 times trailing FCF.

  • Report this Comment On July 16, 2012, at 10:32 PM, Mega wrote:

    "It's the job of the CEO to grow the fundamentals; it's the job of Wall Street and investors to price them."

    If you recall, Warren Buffett believes he has the responsibility to help Berkshire Hathaway shares trade towards fair value. That way, shareholders (large and small, mid term and long term) are all more likely to share in the growth in the value of the business.

    Of course, most CEOs have neither the ability nor the character to pursue this goal.

  • Report this Comment On July 16, 2012, at 10:35 PM, Mega wrote:

    Also, I totally agree with WhichStocksWork. Given the bad buybacks, the idea that management isn't to blame for losses is surprisingly easy to demolish!

  • Report this Comment On July 16, 2012, at 11:52 PM, SuntanIronMan wrote:

    Overall (averaging all of the buyback purchases over the many years), Netflix did a decent job with them. But they would have done better if they has stopped once the valuation had got into noose-bleed sky-high territory.

    And it of course it looks even worse when you are buying back shares around $300, but having a secondary offering at $70 just a few short months later. They might as well have just ignited shareholder money on fire.

  • Report this Comment On July 17, 2012, at 4:15 PM, jdp245 wrote:

    Well, we could blame the Fool as well, since they had Netflix on their buy list for Stock Advisor all the way through $300.

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