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The Truth About Netflix's Future

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Let's get to the point: Icahn isn't taking over Netflix (Nasdaq: NFLX  ) anytime soon. Now that we can set our rabid emotions aside, let's see if there's anything we can glean from this story. More specifically, Icahn's action clearly demonstrates he believes Netflix can be a better performer in the market, and that, with the right corrections in the future, the company is undervalued today. It may sound crazy to put the name Netflix in the same sentence as the word 'undervalued,' but could this stock interest turnaround investors? Looking a bit closer at the Icahn proposition should give us an idea.

Undervalued? Seriously?
Before you get upset, I'm not claiming that Netflix is a cheap stock. At 100 times trailing earnings, and 176 times forward earnings, it would appear to be the antithesis of cheap. On its surface, the stock dodges almost every criterion a value investor may have for a stock: wide moat, sound management, and trading at a significant discount to intrinsic value. There is one metric that would be attractive, however, and it's likely the most appealing part of the stock: cash flow. And Netflix has lots of it.

When Carl Icahn announced his firm had acquired nearly 10% of the company, the stock boosted up nearly 25%, suggesting that investors are just as dissatisfied with Reed Hastings and Co. as Icahn claims to be. Icahn is a rabble-rouser, that's for sure, but he wouldn't take such a large position in the $4.28 billion company without some decent confidence that he can extract value out of the investment.

More over, the corporate raider's investment in Blockbuster was a complete failure, as was admitted by Icahn in an interview. It's unlikely to me that, following such a disastrous investment, the man would jump back into the same game without very strong conviction in his thesis. So what does Carl Icahn see in Netflix, and why is this not the same story as Blockbuster?

In just a couple of years, Netflix stock is down more than 50%. Pundits, analysts, and investors have often criticized the moves of CEO Reed Hastings, and there are some reports that employees have noticed increased arrogance and irrational decision making on the part of the chief. But, when you push all of that aside, Netflix is still the biggest streaming player in town, and likely will be for a while.

The company hauls in $2.5 billion in cash from its U.S. subscription base. There's no doubt that there is a business here, and the trend toward watch-when-you-want programming is undeniable. So is the company worth a second look? Well, even with all that cash flow, some are saying that Icahn just wants to take the company and immediately sell it for a quick profit.

Sell Netflix? Blaspheme!
I can feel the agitation oozing off Netflix bulls, and I apologize. But, realistically, that may be the easiest in and out for Icahn, or any investor who recognizes that Netflix will only face continuing pricing pressure from content producers and competition from ... the competition.

Take a look at who Netflix is in competition with: Google (Nasdaq: GOOG  ) , Amazon (Nasdaq: AMZN  ) , Verizon (NYSE: VZ  ) , or any other cable provider for that matter. Google has over $16 billion in cash as of the last quarterly statement. Amazon has nearly $3 billion, and Verizon has close to $10 billion. With a little bit of leveraging, any of these companies could easily afford a near $5 billion Netflix and work it into their business models, while eliminating many of the operating costs that eats up Netflix's billions in revenue.

Now, Reed Hastings probably puts death by torture and nuclear holocaust above selling Netflix as the worst things that could possibly happen, but probably little else. For a sale of Netflix to occur, it will take an Icahn or a Bill Ackman, who is likely too smart to touch the company, to shake up the upper echelons of management and put some new board members in the seats. Is this likely to happen? As I mentioned in the first sentence of this article--probably not anytime soon.

There are two paths for Netflix right now. Either it improves on its own, and thrives to the levels it previously held, or it gets taken over. If things stay the way they are, and the margins continue to vanish, an activist will eventually take hold of the company. If things get even worse than they are, than it will just happen sooner.

As for an investment thesis, I'd wait for the stock to fall a little more. Give it a few more quarters of bad news, and let the valuations drop to turn-around level; then, buy in for the wild run to follow.

The precipitous drop in Netflix shares since the summer of 2011 has caused many shareholders to lose hope. While the company's first-mover status is often viewed as a competitive advantage, the opportunities in streaming media have brought some new, deep-pocketed rivals looking for their piece of a growing pie. Can Netflix fend off this burgeoning competition, and will its international growth aspirations really pay off? These are must-know issues for investors, which is why we've released a brand-new premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to buy or sell the stock. We're also offering a full year of updates as key news hits, so make sure to click here and claim a copy today.


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