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By Gordon66
February 20, 2004

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Greetings all,

In the "lament of a seller" threat this issue came up, and a figure of 29.65 was mentioned.

As I understand it, according to NFs current guidance the forward P/E is now much higher. The new estimate for GAAP profits (given on Jan 21st) for 2004 is 14.6m to 21.6m. There are 48.5 m shares out, so this equates to .30-.45 a share. At the current price of $35 this works out to a P/E of to 86 to 116.

Here is the press release I got this information from.

In the same press release they raise sales guidance for the year, noting greater than expected new subscriptions. I think the reason for the decrease in projected GAAP profits is (1) new customers hurt earnings due to the free month and the cost of adding 3-4 movies to inventory, (2) NF is spending more on advertising (TV).

The 116 p/e figure reminded me of the last time I started following a stock like NF, 3 years ago. The company was Krispy Kreme, and I think the comparison with KK, which also hit a peak P/E of 116 in its heyday, might be instructive.

KK, as I'm sure you all know, was a story stock that confounded the critics for quite some time with its gravity-defying stock price. In the spring of 2001, on wave after wave of short covering, it hit 30, 40, 50, 60 and finally when I became interested, it had hit 70 (all prices are before a split that occurred soon after I sold my first puts on the stock).

Since then, the stock has been up and down, but is now almost exactly where it was 3 years ago. During this time KK's sales and especially earnings grew much faster than the 25-30% management had been projecting. In fact, except for a blip in 4q02 fiscal, where it had to settle a law suit, earnings grew at more like 50% Y0Y, though less in the very lastest quarter.

Now on the one hand, this stock's achievement of going sideways is much, much better than I was expecting at the time; I saw no reason that management would so significantly under-rate expected growth. If the company HAD grown how management was projecting it would, needless to say, the stock would be trading much lower now.

On the other hand, this performance is a far cry from what holders were expecting, and less than what you should get for such a risky investment. At the time people were really expecting the stock would continue the sort of ascent they had been seeing, and for that reason, most were unwilling to sell or even hedge their positions.

In comparing KK to NF I see some eerie similarities:

(1) a very high P/E on a company that is nevertheless growing fast

(2) a market cap of nearly $2 billion, which falls in the same rough ball park of that awarded to a huge established competitor. For KK I drew a comparison at the time to Hortons, a division of Wendy's corp., with 2000 doughnut stores to KKs 200. Wendy's, with 8000 stores total, had a cap of $3.3 billion on sales that were more than 20 times KKs at the time. Right now Blockbuster has a cap of $3 billion on sales that, you guessed it, are bit over 20 times NFs.)

(3) a CEO concerned with "managing" the stock price with lots of press releases and a quick finger on the split trigger. Since odd-lots no longer cost more to trade, there is exactly one reason to split a $70 stock: to draw in naive investors that perceive it as having gotten cheaper

(4) a "unique" product that people have absolutely fallen in love with; many, many true believers among the stock holders

(5) bears who were too quick to dismiss the strength of the business model and its growth potential (I never dismissed the business, I just said its multiple was too high to offer a high long term return going forward).

Looking at NF vs. KK, I see important differences too, some favorable to NF and some not.

Things that are favorable to NF include:

(1) it is growing sales more than twice as fast as KK was 3 years ago

(2) NF can scale it's business much easier, should the demand be there, than a brick and mortar store can.

Things that are unfavorable to NF are:

(1) NF has no track record of profitability. For KK, there was a solid track record. This can work either way for NF--it could be either much more much less profitable than people currently expect. But uncertainty is bad for a stock, so I count this as a negative.

(2) NF is in a technical field, and so a change to the technological landscape could change its prospects dramatically for the worse at any time. So something that makes VOD come sooner rather than later, or if disposable DVDs get revived, or something else happens, this would be very bad. I can't imagine a technological development that would change it's prospects for the better, since it has 95% of its market already.

(3) A large, well-funded competitor has announced that it intends to adopt the same exact business model. It's tempting to dismiss Blockbuster. After all, Amazon crushed Barnes and Noble. But I'd say there is a key difference. I think Amazon beat B&N largely because of its horizontal diversification strategy. In NF vs. BB online, it will be direct competition in the same narrow market. I'm not saying BB will "win", or will even necessarily be anything but pathetic. But I think it would be equally dangerous to just assume BB online will be pathetic. All BB online has to do to really hurt NF badly is put pricing pressure on them or make them spend much more on advertising. B&N, while losing the war with Amazon, did nearly put Amazon out of business with price-cutting.

(4) An event looming in the foreseeable horizon that would require NF to make an uncertain leap into a completely different business model (digital downloads).

The take away message from all this is that when a company has an extremely high multiple, as NF does presently, it can surpass all expectations in terms of business performance for years hence and STILL only go sideways (where "sideways" is defined as performing about the same as the market overall). I honestly think this is the best one can expect from NF over the next few years.

Gordon66


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