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Netflix's High Stock Price Is Indefensible

BOSTON ( TheStreet) -- Netflix (NFLX - Get Report), the best-performing S&P 500 stock over the past 12 months, recently eclipsed St. Joe (JOE) to become the market's most contentious stock. Having more than tripled in the past year, Netflix has drawn criticism from value investors and been pitched as a short candidate by hedge fund manager Whitney Tilson, founder of T2 Partners, who believes the stock is overvalued. His short bet, so far, has been a loser.


Yet, Tilson's thesis is fundamentally sound. Netflix is approaching monetary hurdles, ranging from contract renegotiation to a transition to Web-based streaming content. Tilson isn't alone, either. Many media executives are baffled by Netflix's stock performance, including Jeffrey Bewkes, CEO of Time Warner, who quipped to the New York Times, regarding the market's optimism for Netflix: "It's a little bit like, is the Albanian army going to take over the world? I don't think so." Netflix CEO Reed Hastings has responded to Whitney Tilson's vocal criticism that the market has overvalued Netflix by citing the company's expanding customer base. This is a tenuous defense.

As is often the case, the timing, not the respective arguments, are critical to determining the ultimate winner of this bout. And the timing is less about when streaming will eclipse the mail-DVD business (it already is) and more about when the market will price in impending competition, rather than an expanding customer base. Netflix's stock is, by all measures, exorbitant. It trades at a trailing earnings multiple of 74, a forward earnings multiple of 35, a book value multiple of 40, a sales multiple of 5.3 and a cash flow multiple of 42, outsized premiums to Internet commerce industry averages. Its PEG ratio, a measure used to account for analysts' growth projections, at 1.6, indicates that the stock is 60% overvalued based on researchers' prediction of Netflix's terminal growth rate.

Netflix has already rallied 26% in 2010 as investors applauded its quarterly report. Adjusted fourth-quarter earnings advanced an impressive 55% to 87 cents, beating analysts' expectation by 22%. Sales gained 34% to $596 million, narrowly missing the consensus. Netflix shares jumped 15% in reaction to the report, which stressed more than 3 million of net new subscription additions, an impressive tally. For the full year, Netflix added seven million net subscribers, amplifying its base 62%. As in a classic S-curve adoption, Netflix expects accelerating additions in 2011. The biggest draw at Netflix, though, is its $7.99 unlimited streaming plan, with more than a third of new subscribers opting for that arrangement.
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