Should Investors Take Icahn's Advice About Netflix?

| About: Netflix, Inc. (NFLX)

For the last few weeks, Carl Icahn has been talking about how cheap Netflix (NASDAQ:NFLX) is and how he is surprised that other companies aren't attempting to acquire the company given its current valuation. Many people see Mr. Icahn as a great investor and his opinion worthwhile, while others may feel like he is simply trying to pump the price of the company he happens to own a part of. When it comes to Netflix, there are two sides to the argument and both sides seem like they have valid points. Those who are bearish with Netflix argue that the company has thin margins, there is a lot of current and potential future competition, it is difficult to find good content at affordable prices and that Netflix is just a fad. Those in the other end of the argument state that internet TVs are replacing convenient TVs, that Netflix has a dominance in internet TVs and that the company has a lot of growth potential outside of the USA.

Mr. Icahn believes that it is very difficult for possible competitors to become serious threats for Netflix. He stated that: "To begin with, I'm not sure you can build the business that easily. It's not like you build a widget factory and you start making widgets. I just don't think you can buy that. You walk in facing in 27 million subscribers." It would be truly difficult for a no-name company to get in the market and reach 27 million subscribers in a short time. Apple (NASDAQ:AAPL) is probably the only company that could generate as many subscribers as Netflix in a short time. Of course, this doesn't mean that the other companies can't steal market share from Netflix.

Netflix users accounted for 33% of the internet video streaming traffic in the prime-time hours in September. This is impressive and something that had never been achieved by any website before. In fact this shadows even a combination of a number of competitors such as Amazon's instant movie service and Hulu. Google's (NASDAQ:GOOG) YouTube accounted for nearly 15%, while Apple's iTunes accounted for nearly 4% of the internet traffic in the peak hours.

Recently, Netflix agreed on a "poison pill" policy to reduce Icahn's influence in the company. Icahn owns 9.98% of the company and he is known as an activist investor, which means he attempts to influence the management of the company whenever he can. According to the company's poison pill policy, whenever an activist investor acquires more than 10% of the company (or whenever a passive investor acquires more than 20% of the company), all other existing investors of Netflix will be able to acquire more Netflix shares for a discount. The results will be twofold: 1) the company's market value will probably drop significantly; 2) the active investor with more than 10% shares will probably end up owning far less than 10% when many of the company's existing investors take advantage of the discounted shares. It looks like the company's fear was justified after all, Icahn has recently admitted that he is still considering a hostile takeover of the company.

Interestingly enough, Icahn acquired most of his shares by buying calls. Back when he was acquiring the company's shares, it was trading for low $50s. Currently they trade for nearly $80. Currently the company is facing a number of issues. While the company is dominant in the USA, its growth rate has been slowing recently. Also, the company's entrance into the European market has been very costly so far. Furthermore, the company will have to pay $2.1 billion in the next year for the content obligations alone. The content obligations of Netflix keep growing at an alarming rate. I wouldn't jump in Netflix before some of these issues are solved.

Last year, the company's share price reached $295 at one point. Back then, many analysts were saying that the company could easily see higher numbers even though the fundamentals didn't support such a number. For example, Goldman Sachs said that the company was a "screaming buy" with a price target of $330. From July to November, the stock price crashed from $295 to $63. Later on, the stock price moved all the way up to $120 per share due to the Santa rally of 2011-12, which was a textbook example of a Santa rally. In the summer of 2012, the company's share price saw low $50s and now they are in the high $70s - low $80s range. In the last few years, the company's revenues increased dramatically, but the earnings growth didn't keep up with the revenue increases. This is because of the company's costly international expansions. On the other hand, the company's gross profit has increased from $454 to $1.16 billion in the last 4 years. This is definitely a good sign for investors of the company.

Should investors buy Netflix? I wouldn't mind initiating a small position of 100 shares and selling covered calls to protect the shares from some possible downside. Because Netflix is usually volatile, the covered calls on this company usually have nice yields. Due to the high volatility of this stock, a possible earnings miss in the near future could send the shares lower. This is why I believe that it is important to use covered calls. On the other hand, a possible earnings beat can ignite a large rally in this stock, similar to the rallies we've seen in the past. In the short term, this could go anywhere but in the long term, it is more likely to go up than down. Then again, investors should only consider this stock for a long term, and those who are planning to retire in a few years might be better off by staying away from this company.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.