Is This the Peak for Netflix?

DECEMBER 24, 2010 WALL STREET JOURNAL



I wonder if there will be a flurry of last-minute gift subscriptions to Netflix this Christmas.

After all, it's a gift you can buy online, so you can get it as late as Christmas morning for that surprise guest. It doesn't cost much: Prices start at $7.99 a month. And Netflix, which delivers TV programs and movies to your home by DVD and over the Internet, can save the recipient money: It lets them cut back on cable—or dump it altogether.


These are boom times for Netflix. It's been one of the big winners from the recession. Last quarter's revenues were 31% higher than a year earlier. Earnings were up 35% and had doubled since the summer of 2008.

In the last year alone, the stock has rocketed from $57 to $184. By my rough calculations, based upon filings from earlier this year, chairman and chief executive Reed Hastings may be sitting on stock-option gains approaching $300 million.

So if the Netflix subscription service is a good deal, is that the same for the stock?

I'm sorry to sound like a Grinch, but that's another story.

There are three things that should make you nervous about any stock.

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These are boom times for Netflix. But is the share price set for a fall?

First: It becomes extremely expensive in relation to earnings.

Second: The CEO gets named "businessman of the year."

Third: The CEO starts arguing in public with hedge-fund managers who are betting against his stock.

In the case of Netflix, I'm afraid, we have all three.

It was bad enough that Reed Hastings was named "Businessperson of the Year" by Fortune. It's uncanny how often this sort of thing precedes a very nasty fall.

Then Mr. Hastings got into a public debate with Whitney Tilson, a hedge-fund manager who is "short," or betting against, Netflix stock.

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Mr. Tilson laid out a strong bear case on Netflix. A few days later Mr. Hastings hit back.

This is never a good sign. I remember watching Overstock.com Chief Executive Patrick Byrne rage against short-sellers while his stock tanked. The only correct way for a chief executive to handle the bears is to make them lose money by keeping the share price rising.

Perhaps none of this would be quite so ominous if Netflix stock weren't so expensive. The stock is trading at a lofty 70 times recent earnings, and 48 times those forecast for the next 12 months. It trades at nearly five times annual sales. These are extremely high multiples.

At these levels, it gets tough for an investor to make a good return. Companies have to run faster and faster just to meet expectations.

The history of the stock market is not kind to investors who pay too much for growth stocks. Over the long haul, study after study has shown that they tend on average to fare poorly. For each winning stock, there are many costly losers. Indeed, some analyses—such as work done by James Montier, now a strategist at fund shop GMO—argue that investors have typically done better investing in the beaten-down stocks that everyone hates than they have in the glamorous ones everyone loves.

That's because unloved stocks tend to be so cheap, and expectations so low, that positive surprises can come quite easily. With go-go glamour stocks, the reverse is true. Even a single disappointment can get punished severely.

I'm a great admirer of successful, entrepreneurial companies—especially those, like Netflix, that seem to have their act together, have reinvented an industry, and have knocked the stuffing out of complacent old behemoths like Blockbuster.

Netflix has built a great franchise. But right now the stock market may be viewing this company's future upside-down.

Yes, the big news is that the business is moving from delivering DVDs by mail, its established model, to streaming movies over the Internet.

Wall Street sees new vistas of growth. I see much more competition. I also see a game where Netflix's key strengths suddenly won't count for very much.

Consider the competition. Everyone and his aunt is getting into the streaming game. It's not just the cable companies.

An Apple TV lets you rent individual movies for $3 to $4 at a time, and TV programs for a dollar. You can rent movies online from Amazon.com. You can buy set-top boxes—from the likes of Roku and Boxee—that let you stream media from different sources. You can watch programs from the Web on Google TV.

These are early days for this industry. It's really just getting going.

And where will Netflix have an advantage? Will they get better deals from movie studios and TV companies than Apple, Google, Hulu or Amazon? If so, why? If I want to download, say, "Harry Potter and the Deathly Hallows"—or "Casablanca"—why should I go to Netflix.com rather than anywhere else?

If the free market works as advertised, this should end up as a low-margin business. Indeed, it may end up as a negative-margin business: If history is any guide, some companies will be willing to sell at a loss to gain market share, and there will be investors willing to finance them, at least for a while. Bring on the deals! Do I really want to pay 45 times forecast earnings to be in this business right here?

Now consider how this new world of online video streaming will neutralize two of Netflix's core strengths.

The first: fulfillment. Netflix doesn't owe its success to an amazing website. It owes it to the remarkably efficient way it handles lots of DVDs. It sends out orders and processes returns quickly. It doesn't make a lot of mistakes or lose many discs. This is tougher than it seems. Most companies can't do it. Netflix, like Amazon, can. It's why Netflix is the champ at mail-order DVD rental.

But this skill is irrelevant to streaming movies. It gives you no edge at all.

The second big change? Under its current business model, Netflix is able to rent the same DVD over and over to different customers. That's extremely lucrative.

But with streaming, all that changes as well. You have to strike deals with studios and TV companies. They can charge you for each use. You lose control, and your edge.

None of this means it's lights out for Netflix. Never underestimate a well-run entrepreneurial company. Maybe it will defy the odds. Maybe the stock will keep rising. But the game is different, and getting harder.

So what should you do if you own Netflix shares? Knowing when to sell a booming stock—if at all—is always tricky. There are no perfect answers, but one of the better ideas I've seen is simply to set up a stop-loss order. Set a price target, maybe 20% below the peak, and if the stock falls to that level, cash out. It won't get you out at the top. But it will keep you in a rising stock and can cash you out of a falling one before things get really bad.

Write to Brett Arends at brett.arends@wsj.com