This Just In: More Upgrades and Downgrades

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At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about.

It's all over but the crying
Last week, we took at look at the incredibly brave -- and incredibly wrong -- recommendation that B. Riley made to buy Netflix (NAS: NFLX) stock ahead of earnings. Prompted by Riley's suggestion, I took at look at Netflix myself, crunched some numbers, and declared the stock's 28-times-earnings price tag "fair." But I also encouraged investors to check back in on Monday and see if Netflix would live up to its potential, or blow its earnings report ...

Well, the results are in, and as you've probably heard by now, they blew it. Despite "beating earnings" for Q3, Netflix reported 800,000 missing subscribers (apparently abducted by aliens, or perhaps Hulu) and gave earnings guidance far below consensus for Q4, warning that early next year, it will begin losing money. The stock fell 35% yesterday, and Wall Street's panicking.

The downgrades are still rolling in, so by the time you read this, I expect the list will already be longer. But at last count, each of Atlantic Equities, Bank of America, Goldman Sachs, and Susquehanna Securities had downgraded Netflix -- some going so far as to say you should sell the stock despite yesterday's massive losses, because it's going down even more.

I disagree. I say that if you liked Netflix at 28 times earnings last week, you've got to absolutely love it at today's 19 times earnings multiple.

Heckling from the peanut gallery
But before I get into the valuation, let's take a moment to examine what's got Wall Street in a tizzy over Netflix. Goldman's comments (kindly summarized for us by the good folks at StreetInsider.com) are illustrative, and there's really not much Goldman liked about Netflix this quarter:

  • Guidance for the subscriber count in Q4 was "disappointing." In particular, Goldman doesn't like the projected fall-off in customers subscribing to hybrid DVDs-plus-streaming subscription plans.
  • The analyst sees dim prospects for Netflix's expansion into the U.K. market, where it sees a high level of competition.
  • Goldman describes CEO Reed Hastings' plans for rebuilding the Netflix brand in the U.S. as little more than "if [we] build it, [they] will come" -- with no "proactive" plans to lead prodigal customers back to the fold.
  • And more generally, Goldman's also worried about "visibility" of earnings growth after the 2012 "reset" year.

All of which is true. To which I'd add the even more serious worries that Netflix still lacks control over both the content it wants to distribute to customers and the delivery systems for this content. DVD distribution remains utterly dependent on a U.S. Postal Service that's in deep fiscal doo-doo, facing a real and self-proclaimed risk of going bankrupt, and pondering several plans to cut back on deliveries and close down distribution centers to cut costs. If USPS follows through on either of these moves, it will hurt Netflix's quality of service in the DVDs-by-mail business. If USPS takes both actions, Netflix's customers just might "go postal" themselves.

And that's just the postal problem. Netflix's new streaming venture arguably faces even worse challenges. It must negotiate for access to content from companies like Time Warner (NYS: TWX) , Disney (NYS: DIS) , and News Corp. (NAS: NWSA) -- each of which has a vested interest in extracting the highest possible price from Netflix. And each of which has a history of playing hardball with counterparties on questions of content. It also must deliver streamed content through Internet "pipes" controlled by the likes of Verizon (NYS: VZ) , AT&T (NYS: T) , and Comcast (NAS: CMCSA) .

If anything, Goldman (and its analytical brethren) may be understating the challenges facing Netflix going forward.

Foolish takeaway
Be that as it may, I personally think Reed Hastings has it in him to turn this ship around. He built Netflix from nothing, into arguably one of the most successful and most-loved media companies on earth (before blowing it up). He certainly knows what needs to be fixed at the company -- after all, he broke it himself!

At 19 times earnings, and a projected long-term growth rate of nearly 30% annually, I think Netflix is a buy. In fact, I'm so sure it's a buy from today's price point that I'm going to head over to Motley Fool CAPS right now and close out my virtual short bet against Netflix. (I beat the market by more than 50 points on that one, by the way. Thanks for asking.) Then I'm going to open a new recommendation for Netflix to outperform.

Feel free to follow along, hold me accountable for this call -- and heckle loudly if it all goes horribly wrong.

Looking for a way to invest in the stock market that's a little less ... shall we say, exciting than an investment in Netflix? Read the Fool's new -- and free! - report "3 ETFs Set to Soar During the Recovery."

At the time this article was published Fool contributorRich Smithdoes not own shares of (nor is he short) any company named above.You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 310 out of more than 180,000 members. The Motley Foolhas adisclosure policy.Motley Fool newsletter serviceshave recommended buying shares of Walt Disney, Netflix, and AT&T.We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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