Netflix, Inc.: The Bear Case From a Bull

It's no secret that I'm bullish on Netflix (NFLX +0.34%). The digital video giant is the largest holding in my portfolio, after all. If the stock looked too risky, I'd be taking at least some of my Netflix profits off the table and investing them elsewhere.

But it never hurts to take a hard, critical look at even your strongest-conviction stocks. On that note, I'm here to ponder what Netflix still could do better -- and what it would take to put my finger on that "sell" button.

Image source: Getty Images.

By the numbers

Okay, so it's difficult to pin a "correct" market value on Netflix shares today. That has been true for years, and will be for a few more years. Without significant earnings or positive cash flows, investors are left guessing at the company's powers to create long-term value -- or destroy it.

I mean, this table is enough to give a value investor the shivers:

Netflix data from YCharts.

The shivers, I say!

Some of these metrics are at least moving in a more comfortable direction now, but it's a mixed bag. In particular, Netflix is more expensive today than a year ago if you measure it by enterprise value over EBITDA profits or price-to-sales ratios. And again, discounted cash flow calculations are useless until Netflix gets its cash profits up into positive territory. Today, trailing free cash flows stand at a negative $1.8 billion.

All of these figures will eventually need to step down from their current nosebleed seats. I'm not asking for an overnight revolution here, and none of the figures in that table are deal-breakers for me. But if the refocus on profitable operations doesn't produce results within the next couple of years, something's wrong on a fundamental level.

Real stumbling blocks

To misquote Elizabeth Barrett Browning's famous "Sonnet 43" here, in honor of April being National Poetry Month: "How might you fail me? Let me count the ways."

Yeah, let's.

1. Netflix needs to keep its foot on the accelerator with generous investments in research and development. Anything less makes it look like the company is ready to rest on its laurels, and that is never a good thing. Research and development spending increased by 31% last year, and I cringed a little when that year-over-year growth rate slid back to 26% in the first quarter of 2017.
2. Consumers are fickle creatures, and management must never forget that fact. Service changes, new price plans, and other subscriber-facing alterations should always be done with a light touch. But Netflix CEO Reed Hastings is only human, and his errors cause mistakes like the Qwikster debacle in 2011. The company survived that storm and the Netflix you see today is pretty close to the original Qwikster vision, but the next misstep could be worse.
3. What if other video providers step out of their time-honored policies and start to put up a real fight? Isn't it high time to admit that Netflix's radical business ideas are working, and that the most effective weapons against it could come from Netflix's own playbook? No, Amazon.com (AMZN +0.53%) is not doing that yet. The most obvious rival still blankets its Prime Video streaming service in advertising for higher-priced downloads and disks at every turn, and that's not likely to change anytime soon. But if some deep-pocketed player wanted to kill Netflix, that's what it would take: Low prices, a large and strong content catalog that's easy to explore and enjoy, and a willingness to break new ground as market conditions change.

That last one is a biggie, and I'm kind of amazed that none of Netflix's many rivals have taken the hint yet. In the early days, cable companies could have simply promoted the snot out of their on-demand offerings. Right about now, the largest threat to Netflix would be a major studio forgetting all about its decades of Hollywood connections and traditions, throwing caution to the wind. The recipe can be find four sentences above. That's what it takes to stop the Netflix juggernaut, and nobody has the guts to pull that trigger.

These are the things that I worry about, and that could end my Netflix ownership in a hurry.

Until then, I remain an unabashed Netflix bull for the long haul. No business is without risks, and I can live with these threats for now.