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.

Netflix currently benefits from the so-called "first-sale doctrine." The first-sale doctrine is a legal precedent, allowing the company to pay just once for each DVD or Blu-ray disc and then rent it out an unlimited number of times to customers to generate sales and profit.

This system is fundamentally illogical and already fading. Film studios bear the cost of investing, filming, editing and marketing content and Netflix, and before it, movie-rental chains such as Blockbuster, bear no risk and enjoy seemingly unlimited aftermarket rewards without paying a percentage to studios. As content migrates online, eventually all devices will be synched to the Web, and all video will be streaming. Netflix doesn't own the Internet, or even any content, so its only bargaining chip with studios will be its technology platform and customer base, which has no incentive to stay with Netflix, unless the company has the best prices and offerings. Netflix has no competitive advantages in streaming so, eventually, it will suffer margin compression, at best, and a potential mass-migration of customers, at worst.

The debate is not if, but, when, this will occur. Whitney Tilson and others argue that it is already occurring. Value-oriented Morningstar issued a report last week, suggesting that Netflix's stock is well above fair value. The researcher is keen on companies that possess an "economic moat", some advantage that keeps competitors at a perpetual disadvantage. Netflix lacks this moat. In terms of hours of entertainment delivered, streaming is already outpacing DVD. According to Tilson, who lists the top 100 films from the American Film Institute's list, Netflix has streaming movie offerings inferior to those of Apple ( AAPL) iTunes, Amazon ( AMZN) OnDemand and Vudu, partially owned by Wal-Mart ( WMT). For streaming television, Tilson ranks Netflix fifth, behind Hulu and others.

Netflix's major studio deal is with TV channel Epix, allowing it to stream movies from Paramount, MGM and Lions Gate 90 days after they're first shown on television, which is roughly three months after the DVD release. This presents a huge lag between DVD release and the movies showing up on Netflix streaming, but Netflix purportedly pays $200 million annually for this deal, a significant sum relative to its cash-flow intake and liquidity balance.

Another deal, announced in December with Disney ( DIS), to stream television content from ABC, ABC Family and the Disney Channel, is costing Netflix $150 million for just one year of use and, again, with a notable lag between run date and streaming release date.

To contextualize that price, Netflix, which has an admittedly ample balance sheet, still carried just $350 million of cash and equivalents at fourth quarter's end and $236 million of debt. That cash could easily be depleted in order to ink just one or two new deals for online content. Morningstar forecasts 18% average annual growth over the next five years and a subscriber base of 40 million for Netflix by 2015. Still, it believes the operating margin will stagnate, or perhaps, decline from just over 13% and sees heightened competition.

Morningstar's fair-value estimate, at $110, suggests that Netflix's stock could drop 51%. It awards Netflix a one-star rating out of a possible five and a "high uncertainty" ranking. Buyers, beware.

-- Written by Jake Lynch in Boston.


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