Netflix investors flying without a safety net

Don't let Reed Hastings or Wall Street's renewed love for the stock fool you. The problems that led to the company's 2011 implosion have not gone away.

By TheStreet Staff Jan 28, 2013 1:40PM

Hollywood copyright Comstock, SuperStockBy Rocco Pendola thestreet logo

 

I'm fielding enough questions on Twitter and via email about my prediction that Netflix (NFLX) will hit $300 to warrant further commentary.

 

I made the call last week on TheStreet: The Anti-Apple: Netflix to $300 by Summer. Since first telling investors to prepare to buy NFLX, the stock has soared 194%; it's up 74% since I first predicted $300.

 

My Netflix take just illustrates this market's senselessness.

 

I know it sounds crazy. I write about how much I love the Netflix service. How much better it is now than in 2011. I called the move to $100. Called the move past $100. And now I am forecasting a retest of the stock's all-time highs. Meanwhile, Apple (AAPL) crashes with dim light at the end of the pipeline.

 

It's nonsense, no question about it. I'm with you. As I've said before, valuation means nothing in this market, nor should it.

 

Just as I have no problem with Amazon.com's (AMZN) 3,400 price-to-earnings (P/E) ratio, I cast no pebbles at NFLX's lofty 585. Price-to-earnings no longer works as a valuation metric. Better to use it to gauge investor confidence.

 

This new and more relevant way of using the P/E ratio doesn't exonerate investors from doing hard work and struggling with the seemingly irrational -- NFLX up, AAPL down, Amazon's P/E, among other examples.

 

AMZN gets the benefit of the doubt because Jeff Bezos has executed strategically for more than a decade. AAPL no longer receives the same pass because, simply put, Steve Jobs is dead. Investors have higher levels of confidence in Bezos's ability to follow through than they do Tim Cook's. I don't completely agree with that, though I do see where it's coming from. What matters is that the collective mindset is out there.

 

We had pretty much the same scenario with Netflix in 2011 as we have now. Everybody loves it. The business appears to be humming. TheStreet's Jim Cramer hits the nail on the head; Netflix is everywhere. You buy a television set, it's there. Buy a streaming player, it's there. Heck, Netflix often has its own button on the accompanying remote control.

 

No media company has done a better job making itself ubiquitous. Not Pandora (P). Not Sirius XM (SIRI).

 

Netflix achieved this level of saturation -- and continues to scale onto consumer electronic devices and such -- because people love the service. If you make hardware, there's real value in making sure Netflix receives primary placement on your television or streaming device. Consumers want and expect to see it.

 

I like the service so much I would pay up to $20 a month for it.  

 

But Netflix's business model faces a predicament yet to be solved. Sooner or later, Reed Hastings will have no choice but to do another 180 and raise prices. He cannot keep taking on debt amid plummeting free cash flow forever. Theoretically, he could, but, even in this irrational market, it's not a sustainable practice.

 

The "virtuous cycle" -- more subscribers equals more money for content equals more subscribers and even more money for even more content -- sounds great when Hastings smoke-and-mirrors it on conference calls. He went back to that talking point just last week. And, like I did in 2011 months before NFLX crashed, I will repeat my response to this nonsense until I'm blue in the face.

 

It's a vicious cycle.

 

Not all content owners are happy with the idea of giving away their premium content to millions of subscribers for eight bucks a month. Don't expect too many more big media outlets to make the same mistake Disney (DIS) made. As Netflix attracts more subscribers, it will have to attract more and better content to keep up the pace. To do this, it will have to charge more. Simple as that. I was right in 2011. I am right now.

 

The only difference? In 2011, I let emotion take over as NFLX ran to $300. I would not give in and say, yeah, get long because this thing's going higher. I'm smarter after having been through that rodeo.

 

This irrational market will help NFLX continue to soar. Most likely after a slightly bigger breather than it took around $100. But don't let Hastings or Wall Street's renewed enthusiasm for his stock fool you. The problems that led to 2011's implosion have not gone away.

 

 

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