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Netflix Can Multiply Profits Eightfold -- Making Today's Drop a Joke

Stocks in this article: FOXA NFLX TWX

NEW YORK (TheStreet) -- Seemingly forever, Netflix (NFLX) has been portrayed as the overvalued, underprofitable poster child for that darn nutty Internet sector. So could the movies-on-demand giant really be about to earn $35 a share within a couple of years?

RBC Capital analyst Mark Mahaney thinks so. And that view is not as crazy as you might think.

Netflix shares are down nearly 6%, or almost $27, to about $425.20 as of 1 p.m. Tuesday. The drop follows a report of second-quarter earnings that slightly topped most estimates for both profit and subscriber growth. Net income more than doubled to $71 million, or $1.15 a share, from $29 million, or 49 cents a share, in last year's second quarter. But Netflix said third-quarter earnings would be lower than expected because it's planning to take a bigger loss in Europe to expand faster.

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"Red is the new black," said long-time Netflix bear Michael Pachter this morning on CNBC, riffing on the title of Netflix's hit show Orange is the New Black.

But of all the discredited reasons to sell Netflix, the most discredited of all is fear of short-term losses driven by CEO Reed Hastings' decisions to put more metal on the pedal. Bears have been fooled so often by Hastings' moves that Netflix's stock chart has long resembled an inverted W -- selloffs like today's followed by booms. (Some of those "booms" look like little bumps now that the stock is above $420, but looked pretty darn big at the time.)

We have seen this movie before.

The best thing about this company has always been its ability to balance aggressiveness with building a solid foundation for profitability. This year, consensus estimates say Netflix will earn $4.12 a share, more than double last year's profit, as revenue jumps 25% to $5.5 billion. And that's with international operations that are still in startup mode on track to lose $200 million or more this year.

The question is, what does Netflix look like when its European business grows up? 

Mahaney says it looks like 100 million subscribers, paying $10 a month vs. $8 and change now, with 30% operating-profit margins (meaning, 30 cents of every dollar it collects becomes pretax profit). The math says that generates $3.6 billion in operating income, or just under $35 a share. At that rate, Netflix's valuation today is about seven times those operating earnings.

The next question, is how long will it take and how realistic are the assumptions?

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