In this week's Small-Cap Spotlight, Frank Curzio and Larsen Kusick take a look at Netflix (NFLX) - Get Report. Shares of the online movie rental company spiked over 50% in two months to $27, but does the stock have more room to grow, or is it time to take profits?

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Curzio: Flawed Business Plan

Back in July, shares of Netflix were under pressure after the company reported that its current subscriber base was 6.742 million -- or 55,000 lower than its previous quarter. This compared to the 800,000 net new subscribers that

Blockbuster

(BBI) - Get Report

, its chief competitor, added during its heavily promoted "Total Access" campaign.

At the time, Netflix reduced its third-quarter estimates sharply but said it would look to cut prices of its unlimited program by $1 in an effort to increase its attractiveness to new subscribers. Also, management said this move would result in less money spent on marketing.

Fast forward to the current quarter, which was reported on Oct. 22, and it seems these initiatives worked well. Netflix handily beat estimates and also raised its guidance. But I am not convinced that a plan that includes lower prices and reduced marketing is sustainable in an industry that seems to be near the top of its growth curve.

Its strategy leaves the door open for competitors to do the same. If this is the case, Netflix would probably have to raise its marketing costs to attract new subscribers in the long term.

This will put Netflix in the same position -- a competitive pricing war with higher marketing costs -- as when the company missed its quarter back in July.

Looking at the future, Netflix is basing its growth strategy on online video, which amounts to watching movies on your PC. Personally, I would rather watch a movie in high-def on my 52-inch LCD TV than my 19-inch computer monitor. With flat-screen TVs selling like crazy, it's possible, and even likely, that most consumers share my sentiment.

Looking past the PC, Netflix wants to make it easy and inexpensive for consumers to view its online video content through the television. But this initiative seems a very long time away.

In its last conference call, management said that it could take 10 years to get most of its content online and then stated, "We are exploring ways with a variety of partners trying to understand the best ways to provide inexpensive viewing of online content on television."

As of today, even the most tech-savvy guys have a hard time explaining how to download movies to watch them on TV in hi-def and surround sound. So getting the average movie watcher to do this in the short term is highly unlikely.

Netflix boasts a very strong balance sheet with almost $6 a share in cash and no debt. But shares are trading at 34 times next year's projected earnings on a company with a long-term growth rate of only 18% according to Capital IQ. Also, subscriber growth is projected to slow dramatically, dropping to roughly 19% by year-end 2007 from more than 50% in 2006.

So now we have a company in a price war whose growth model is dependent on online video, which does not seem to be a short-term reality. The reduction in marketing expenses cannot be sustained unless Netflix continues to lower prices, which is not something investors want to see from a growth company.

I would use the recent 50% jump in the stock to take some profits off the table. The company's strategy may work in the short term, but it will be difficult to sustain.

Kusick: Don't Get Suckered by Sentiment

To me, both Netflix and Blockbuster are classic sentiment plays. Both companies go through cycles in which results are poor relative to high analyst expectations, then surprise to the upside months later when expectations fall too low.

In this case, Blockbuster provides a clear road map for Netflix. In 2006, Blockbuster spent its first three quarters telling analysts it would have 2 million online subscribers by year's end. At the end of the second quarter, the company had added just 200,000 subscribers, yet kept telling investors that it was still targeting 2 million.

Following Blockbuster's weak second quarter, shares were languishing below $4 and it was assumed management was blowing smoke about its subscriber goals. Analysts spent the rest of the summer and early fall trimming estimates and lowering subscriber expectations.

Then the company effectively turned on the marketing spigot, rolling out its Total Access plan, and it announced in January that it hit a total of 2.2 million subscribers at year-end, surpassing the 2 million target. Shares rallied from below $4 in October to above $7 in March, as analysts adjusted their models upward, anticipating significantly better forward results based on the new-found growth of Blockbuster's online service.

But any investor who jumped onto the Blockbuster bandwagon was greeted by a nasty surprise in May 2007, as the company missed first-quarter estimates by 11 cents. As it turns out, the online business remains a difficult space to make money in. The business wasn't generating the kind of margins that investors and analysts expected because the growth in Total Access forced the company to carry more inventory and spend more on advertising, while keeping prices down to compete with Netflix.

Anyone looking to invest in Netflix should be aware of this story because it illustrates the difficulties of the current DVD rental business, as well as the link between stock performance and investor/analyst sentiment. When everyone thinks that things are a lot better -- that's when investors should be most wary about this business.

As Frank outlined, Netflix's recent history has a lot in common with the Blockbuster story. Shares of Netflix were stuck in a brutal downtrend, falling well under $20 this summer as management lowered guidance and announced a $1 price reduction on its most popular plans.

I don't think it's a coincidence that Netflix's current 52-week low occurred on July 24, the same day analysts were issuing downgrades and generally bemoaning the company's terrible outlook. A report that day from investment bank Jefferies summed things up with the title, "No Relief in Sight; Maintaining Hold and $16 Price Target."

Today, shares of Netflix are trading more than 70% above those July lows. That's right, 70%. What changed? Well, it seems that Blockbuster pulled back on its marketing of Total Access and decided to tighten up its pricing in the hope of boosting margins. (Translation: The company felt it had done enough in playing catch-up with Netflix and decided to focus on trying to turn a profit by raising prices and reducing ad spending.) So, just one quarter after Netflix management slashed its expectations for the next year, it raised them.

When you piece together the recent story of Netflix and Blockbuster, you get a fairly simple picture of what drives these two companies: pricing and ad spending. Anytime one falls behind (at which point its stock is probably in a significant decline), it can just cut prices and put on the "full court press" in its ad campaign in order to boost subscriber growth. Analysts will complain about the lower forecasted revenue and higher costs, but in the end the negative sentiment will allow the stock to bounce as subscriber momentum picks back up.

Netflix shares look to be very close to the high point of this cycle.

Ultimately, the DVD-rental business will remain a low-margin business that hangs around until someone figures out how to do video-on-demand (or whatever term you want to use for a service that allows customers to download movies and watch them on a TV without needing to use a disk) in a simple and customer-friendly way.

The future of this business would take up at least another 1,000 words, but for now, I think Netflix's best bet is to focus on its current business and try to find the right balance of pricing and subscriber growth in order to maximize profitability. Unfortunately, I don't see the upside when you have Blockbuster essentially trying to do the same.