Netflix, Hastings Screwed Up Royally, But Stock Is Now Wildly Undervalued On A Risk/Reward Basis

Oct.26.11 | About: Netflix, Inc. (NFLX)

By Scott Rubin

The plunge in Netflix (NASDAQ:NFLX) has been shocking. The stock was trading at $300 in July and is now at $78 and change. This outcome was predicted by a number of vocal short-sellers, including T2 Partners' Whitney Tilson.

Most of these short-sellers, however, were completely run over as NFLX's share price went from $53 at the beginning of 2010, to $300 this summer. Hindsight has revealed, however, that the shorts were right and the stock was extremely overvalued at its previous lofty valuation. Its current $78 price tag and $4 billion market cap is likely a bargain.

The company's problems began with a 60% price hike this summer for customers who were receiving both DVDs and using the company's online streaming platform. The move by Netflix's CEO Reed Hastings was implemented as part of a transition process for the company away from DVD shipments and an enhanced focus on streaming. It was also designed to offset higher content costs. Netflix, however, made a terrible mistake in moving so aggressively on the pricing front and severely underestimated the reaction of its customers.

Yesterday's Q3 earnings results revealed that the company lost 800,000 subscribers, which was way beyond what Wall Street was expecting. As a result, the stock, which had already been battered, fell another 35% to its current price of $78. The company's problems have been exacerbated by an aborted plan to split the DVD and streaming businesses apart completely and re-brand the DVD business Quickster. After even more complaints from subscribers, this idea was scrapped.

The entire saga has been extremely messy and Reed Hastings has screwed up big time. It is almost inconceivable that he could have been so out of touch with his subscriber base and subsequently decimate NFLX's share price and brand reputation as a result. The situation is very bad, to be sure. Hastings himself attributed the mistakes to overconfidence, "moving too quickly," and even hubris. Given the fact that NFLX is trading at around a quarter of its peak stock price in July, however, at this point investors are throwing the baby out with the bath water.

Although earnings estimates have been adjusted downward as the Wall Street Journal's Dan Gallagher notes in a piece titled "Why Netflix Is A Lot More 'Expensive Now,'" the premise of his argument is misleading. He argues that at around 44 times 2012 EPS estimates, which have gone from $6.16 to $1.75, the stock is now actually more expensive than it was before today's big plunge - at least on a valuation basis. On the surface this may be true, but earnings estimates are now all over the place with some analysts still arguing the company may earn $5 a share in 2012.

Furthermore, the reason that profitability is expected to be volatile in upcoming quarters is because the company is trying to right the ship and is also ramping up spending on content. The opportunity in Netflix does not exist in the upcoming quarters, but rather in the next few years. With that in mind, investors should not worry too much about near-term earnings volatility, but rather if the company can execute on its long-term strategy.

There are two things that value-focused investors should be focusing in on right now when evaluating Netflix. The first is the streaming model. This company is now trading at a valuation of $4 billion. If Netflix can implement its plan to become a dominant global player in subscription streaming, the stock could easily go up 10 times from here in the next decade. The opportunity could be truly massive, although it is far from a slam-dunk.

Given the current value of the company, however, you are getting the right odds to bet on Netflix's long-term success. The long-term bullish thesis for Netflix is still the same as it was when the stock was trading at $300. At $300, however, investors had to be very confident that the company could pull it off. At $78, on the other hand, the stock offers excellent risk/reward because even if you think its chances of being the global leader in the content streaming business are slim, the potential upside is so great that it adequately compensates you for the risk.

The other factor to look at when evaluating the business is the company's brand recognition. Certainly, the past few months have tarnished the brand, but it can be argued that it is still very, very valuable. If there is a more visible, ubiquitous brand out there that belongs to a fast growing company worth of only $4 billion or less, I would sure like to know about it. Netflix is valuable. Despite the recent hiccups, the company has made significant inroads with consumers.

If large competitors such as Amazon (NASDAQ:AMZN) and Apple (NASDAQ:AAPL) along with DISH Network (NASDAQ:DISH) decide to continue to push into the streaming business, Netflix will be acquired. If they don't, Netflix will likely win the battle and the share price will move substantially higher eventually.

At $300 this stock was fool's gold. At $78 it is a bargain, which is tantamount to a call option with huge upside. That is not to say that NFLX could not sink as low as $30 or $40 - it could. At current levels, however, and hundreds of dollars of potential upside over the next few years, that is a risk worth taking.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.