It may not be the best idea to go on record taking the opposing view of David Gardner when it comes to picking stocks. However, I think the time has come to take profits in Netflix (Nasdaq: NFLX), especially if you followed David's buy recommendation about 500% ago.
Priced for perfection
Don't get me wrong. Netflix is a great company that has grown like very few companies over the last several years. But this has created expectations that now have the stock priced for perfection. Trading at a P/E ratio of nearly 50, Netflix is valued at a premium more than twice that of the S&P Index, which trades at about $20. High-flying growth stocks such as Netflix trade at such a premium to the S&P because investors believe it can sustain its impressive earnings growth in the future. When this growth slows, however, look out below. Netflix earnings are still growing, but if last quarter's results were an indication, the slowdown may have started.
Margin story waning
While much of Netflix's earnings growth has come through monthly subscription revenue from its increasing customer base, the real story has been the company's ability to increase profit margins. Margins have grown from 5.6% in 2007, to 6.1% in 2008, and 6.9% in 2009. However, this upward trend will prove difficult to uphold in 2010.
Of particular note is the total dollar amount spent to attract new customers, which was about $75 million in both the first and second quarters of this year. In Q1, this was enough to bring in more than 1.7 million net new subscribers, while that number fell to 1.1 million in Q2.
Competition increasing
The DVD-by-mail segment of Netflix's business faces increasing competition from DVD vending machines offered by companies such as Coinstar (Nasdaq: CSTR) and NCR (NYSE: NCR). These kiosks allow consumers to rent DVDs at $1 a night, without have to pay a subscription fee or wait for mail delivery.
On the other hand, many of Netflix's customers are switching to less expensive subscription plans that allow only one DVD rental at a time, along with access to Netflix's online streaming service. This has lowered shipping costs for the company, but has also decreased revenue per user. In this segment, the company faces established competition from the likes of Amazon.com's (Nasdaq: AMZN) non-subscription streaming services, as well as various cable television options -- not to mention Apple (Nasdaq: AAPL) and Wal-Mart's (NYSE: WMT) foray into the space, which should prove to be even more formidable competition for the company.
Netflix is still an exceptionally well-run company with a solid business and the promise of future profits. However, I believe that continued success at this rate will be more costly, and will come at the expense of the company's margins.
