As much as I enjoy streaming Dexter reruns on Neflix (Nasdaq: NFLX) and getting a new DVD in the mail every few days, the company's stock has just run too far for its own good. Even as fellow Fools make the case for buying the stock and analysts upgrade Netflix to a "buy", it just doesn't pass my smell test for the opportunity of a business like this. How big can a DVD mailing business really be?

A value problem
Netflix currently gets all of its revenue from the U.S. market and doesn't give any indications of aggressively expanding internationally. There will be a Canada launch sometime this fall, but that only includes streaming video, so the value proposition for customers isn't nearly as compelling as the U.S.

With very little in the way of international expansion, I assume Netflix will need to grow into its $7.5 billion market cap in the U.S. market, and that's where the problem arises. I like to be able to at least envision a price/earnings ratio of 10 sometime in the foreseeable future for a growth company like Netflix. So, using a desired 10 P/E ratio means Netflix would have to make $750 million in net income per year in the foreseeable future.

Currently, Netflix charges an average of $12.29 per household per month, and about $1 is driven to the bottom line. So an average customer accounts for $12 of net income each year. That would require 62.5 MILLION households to subscribe to Netflix, or 54.4% of the 114.9 million television households in the U.S., according to Nielson. That is more than double the 26% penetration that Netflix has achieved in the San Francisco Bay Area, its most saturated market. Is that really possible?

Competition is coming
So far, Netflix has fought off competition from Wal-Mart (NYSE: WMT), Blockbuster and now Amazon (Nasdaq: AMZN), which is looking into a streaming content model. But if the movie rental/streaming media business is as big as the market thinks, competition will come out of the woodwork to grab share. Remember when GE's (NYSE: GE) NBC unit, Disney (NYSE: DIS) and News Corp. partnered to build Hulu because they were sick of Google's (Nasdaq: GOOG) YouTube? The same partnership could easily happen especially with streaming content Netflix doesn't own.

Even if a scenario like that doesn't play out, Netflix must negotiate agreements with each studio for its content, and it's unclear how tough studios like Starz will handle upcoming contract renegotiations. New deals could lead to higher costs for Netflix and possibly higher prices for consumers, as we've seen in the cable TV business.

On the bright side, the smartest thing Netflix did recently was partner with Apple (Nasdaq: AAPL) to provide its service on Apple TV and add an iPhone/iPad app. Competition from Apple would have given me nightmares if I were a Netflix executive.

Falling revenue per customer
Netflix has added millions of customers the past few years by adding streaming content, but new content has only added customers, not increased revenue per customer. This should raise red flags as it would in any retail or restaurant operation.


2Q 2010

2Q 2009

2Q 2008

Revenue Per Customer




Gross Profit Per Customer




Falling revenue per customer isn't all bad; low prices bring in new customers (like myself) who wouldn't find value at higher prices. And to Netflix's credit, gross profit per customer has held up well even with the drop in revenue.

Time to sell
I don't believe the headline growth rates Netflix is putting up are sustainable for long. For Netflix to reach the valuation I outlined above, it would need to have subscribers in 26% of households in the U.S. and approximately 16% of the 200 million or so households in Europe given current operating conditions. I don't believe that's possible given little plans to move outside the U.S. market, no history of expanding its product line beyond subscription DVDs, and the threat of competition.

What do you think about Netflix stock at its current price? Leave your thoughts in the comments section below.