This Just In: Upgrades and Downgrades

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. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

Riding the Netflix roller coaster
After rushing out of the gate in January, shares of video streamer Netflix (NAS: NFLX) are now entering their third straight week of nonstop decline -- and maybe for good reason. Amazon.com (NAS: AMZN) is stubbornly sticking with its offer to undercut Netflix's pricing with "free streaming with Amazon Prime."

This month, FiOS aficionado Verizon (NYS: VZ) announced it would ally with Coinstar (NAS: CSTR) to offer a streaming service, too. And just this week, Comcast (NAS: CMCSA) piled on with a third alternative to Netflix -- one that like Amazon's, could undercut Netflix on cost by coming free with certain tiers of service. The hits, as they say, just keep coming.

But fear not, Netflix investor. According to the analysts at Raymond James, there's good news here: Despite a host of also-rans appearing to challenge its business, Netflix remains the "clear leader in digital streaming." Growth in paid subscribers at the service has been "strong," and despite all the bad headlines of late, the analyst thinks Netflix could very well be worth $104 a share.

Problem is, these shares currently cost $109.

The trouble with Netflix
And this, in short, is the bad news. Even a "clear leader" can be overpriced, and according to Raymond James, Netflix is just that. Overpriced, and doomed to "underperform" the market from here on out.

Why? RJ offers up a number of reasons, ranging from the fact that with 22.8 million subscribers on its rolls already, Netflix is now running up against "the law of large numbers," and finding little room to grow. Analyzing data from Google's search archives, RJ argues that "searches" for Netflix are "approximately flat" year over year. Instead of signing up new converts to its business, Netflix seems to be spending more time "churning" its old customers over and over, with 31 million members turning the service off-again-on-again over just the past three years.

This could prove problematic.

At 26 times trailing profits, Netflix needs strong future subscriber growth -- and strong future profit growth -- to justify its valuation. Instead, analysts say the best we can hope to see going forward is an average of 18% annual profits growth over the next five years. And while fast, that's simply not fast enough to justify the stock's price, which is up 51% since the year began, even after the recent sell-off.

Even more worrisome, Netflix may not be even as profitable as it looks. While the company claims $226 million in GAAP net earnings for the past year, actual free cash flow at Netflix (cash from operations, minus capital expenditures and spending to build out the firm's DVD library) comes to approximately $183 million -- or nearly 20% less than reported net income.

Foolish takeaway
Already expensive in relation to GAAP profits, Netflix looks even more overpriced when valued on its free cash flow. Raymond James is right about the company being best-in-class among the streaming providers. Even so, the mere fact that this class is so large -- and getting larger by the day -- means there's more competition for subscribers and bigger bidding wars among rivals looking to lock up Hollywood content for their services.

Long story short: The future for Netflix looks like one of slower growth, higher costs, and lower profit margins. These aren't exactly the makings of a Hollywood blockbuster -- but they may make for an excellent sell thesis. That's why I'm personally taking Raymond James' advice and reopening my own virtual "short" position on Netflix on Motley Fool CAPS today.

Think I'm wrong? Follow along.

On Motley Fool CAPS, Rich's skepticism has served him well, and racked up a record of 72% outperformance over the S&P 500. Even so, he doesn't hate all stocks equally. To learn more about one stock Rich likes (at least, more than he likes Netflix), read the Fool's new report on "The Next Trillion-Dollar Revolution."

At the time thisarticle was published Fool contributor Rich Smith does not own shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 407 out of more than 180,000 members. The Motley Fool has a disclosure policy.We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool owns shares of Amazon.com. Motley Fool newsletter services have recommended buying shares of Coinstar, Amazon.com, and Netflix.

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