No Matter How Successful, Netflix Can't Shake the Bears


Netflix (NFLX) must be one of the most successful underdogs in business history. For 13 years, it has grown in spite of -- and perhaps because of -- a series of constant threats. But even as the stock hit a record high this month -- popping briefly above $200 in early December -- Netflix seems to be facing some of its most daunting challenges yet.

Founded in 1997, Netflix had to distinguish itself from a pack of DVD-rental rivals (, DVD Express) that are now defunct or forgotten. A year later, Blockbuster (BLOAQ) started selling DVDs, initiating a bloody battle that would force Netflix to lower fees and Blockbuster to redesign its entire business to try to kill Netflix.

The result is well known: Blockbuster is bankrupt. Its stock trades on the pink sheets, and the company is valued at 1/288th of Netflix's market cap. Investors who shorted Netflix aggressively through the last decade have come to regret it: Netflix shares have increased nearly 25 times in value since the company's 2002 IPO.

Sisyphean Battles

Given that history, it seemed almost bizarre this month to see Netflix CEO Reed Hastings writing a long and detailed defense of the company on Seeking Alpha. Hastings was replying to another long, detailed article on that financial site from Whitney Tilson, a value-fund manager who believes Netflix is overpriced and poised to see margins wither way.

Tilson is shorting Netflix; Hastings thinks that will be a mistake. Netflix has emerged from a series of victories in the past several years only to enter another Sisyphean battle with short-sellers. And the interesting thing is, the shorts seem to have a scarily compelling case.

Hastings forthright move was a rare one for CEOs. Most companies would balk at the idea of defending a company's future financial performance fearing a public relations nightmare -- or the risk of spurious but costly shareholder lawsuits if the defense proves to be too optimistic.

The Bears' Argument

But as laudable as Hastings' move was, and as spirited as his counterarguments came across, the immediate risk that he faces with his open response to Tilson is that he failed to deliver a knockout blow. At best, he made it clear that Netflix's future is uncertain. But by responding in such a public manner, he also called broader attention to the concerns held by bears and may have given them weight.

Tilson detailed a long list of potential problems that could slow Netflix sales or pressure its margins. Among the most concerning were that Netflix's subscriber base would saturate faster than many expect, that the cost of building a robust inventory of movies and TV shows would prove unwieldy, and the transition from DVDs to streaming content will have a negative effect on cash flows.

In short, many of the issues Tilson cites will either slow sales growth or push up costs as Netflix approaches its goal of being a streaming-video powerhouse. Hastings concedes that Tilson "only has to be right on one or two of these issues in 2011 for him to make money on his short of Netflix" before asserting, "Odds are he is wrong on all of them, in my view."

Great Skill and Good Luck Needed

It's not unusual for bulls and bears to argue over a the fate of a stock. What's less common is the kind of debate you see with Netflix: Both camps adhering with such passionate conviction to their views for so many years.

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Who is right this time? The bears have a strong case. The coming year will be crucial for Netflix's plans to transition from a DVD-by-mail company to a service that streams movies and TV shows over the Internet. And given the many uncertainties in streaming video and the risks that Netflix must navigate around, it'll take a mix of great skill and good luck for Netflix to keep growing.

Yet if past is prologue, the bulls may be right. Netflix faces some tough competitors in this new field. But the company isn't blindly rushing in late in the game. It has slowly and deliberately laid the groundwork for streaming video, building it piecemeal over the past four years after even more years of careful planning. It has faced competition from Apple (AAPL) and Amazon (AMZN) without seeing its growth slow down.

Following Apple's Lead?

And while it's impossible to predict how many titles Netflix will stream in the future and at what cost, it does have one powerful negotiating chip: It's popular with users. The site's interface is simple and intuitive, and the $7.99 monthly rate for streaming videos is appealing. Apple leveraged the popularity of iTunes to win concessions from music studios. In videos, Netflix seems best positioned to have that leverage.

The bearish criticism of Netflix's stock that will be the most persuasive in the near term concerns its valuation: It's trading at 66 times its estimated 2010 earnings. That's three times higher than its P/E ratio of two years ago. A correction in the stock is overdue -- and would make short-sellers happy.

But they may have to wait much longer for their predictions of Netflix's demise to come true.

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