Money Matters - Simplified

This Just In: More Upgrades and Downgrades

 At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." So you might think we'd be the last people to give virtual ink to such "news." And we would be -- if that were all we were doing.

 

 But in "This Just In," we don't simply tell you what the analysts said. We'll also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we track the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

What should we watch?
The Wall Street Journal isn't prone to overstatement. To the contrary, the prototypical "we're so serious, we don't even have a comics section" newspaper usually makes a point of keeping its emotions in check. So when the Journal comes out and describes Netflix's(Nasdaq: NFLX) share price gains as "monster," you know there has to be something big afoot.

There is. The Journal puts Netflix's share price appreciation at 238% year to date -- a clean triple, plus a little walking-around money. Some investors have done even better. Caris & Co.is up an even 400% on its Netflix bet, placed back in June 2009. Little wonder, then, that the boutique investment banker declared victory, cashed in its chips, and downgraded Netflix to "average" yesterday. But is now really the time to walk away from the table?

Piper plays a different tune
It isn't time to bail, according to Piper Jaffray. Looking at the news that persuaded Caris to call it a day, its competitor announced yesterday that it's doubling down on its Netflix bet and raising its target price on the shares all the way to $202. So, is Piper chasing a pipe dream? 

Piper has been a Netflix fan even longer than Caris, and has reaped even greater gains. Bullish on Netflix since 2007, Piper has a 663% paper profit on its recommendation. The fact that Piper's putting so much greater profits at risk by letting its money ride, I have to say, suggests even greater faith in the stock. But is its faith misplaced?

The never-ending, streaming story
By now you know the story. Netflix, which cut its teeth fighting the likes of Wal-Mart andBlockbuster for dominance in rent-by-mail DVDs, is rapidly growing into its name, renting its flicks primarily over the Net through subscription-based, streaming video. As fellow Fool Rick Munarriz pointed out Monday, this makes Netflix ever more a rival to such "virtual" businesses as Amazon.com (Nasdaq: AMZN), iTunes magnate Apple (Nasdaq: AAPL), and the multitude of companies crowding into the streaming space -- Hulu, Vudu, and their ilk.

Netflix is pushing its customers ever so gently away from the concept of getting their movie fix courtesy of the USPS, at $0.44 a pop. It's offering customers the option of going the streaming-only route for $1 a month cheaper than what they've been paying, or sticking with the DVDs-by-mail service at prices $1 to $6 higher than they previously paid. Obviously, many people will choose Option A, and Piper sees this as a good thing, because stamps cost Netflix money.

While average revenue per user (ARPU) may decline as customers choose the cheaper streaming-only option, the higher prices Netflix charges the nonstreaming Luddites will help make up the difference in the short term. Ultimately, says Piper: "we expect more attractive streaming-only pricing ($7.99/mo vs. $9.99/mo with one DVD) will cause a continued migration to streaming-only, which will lead to continued decline in ARPU, but increasing profitability per sub."

Profits, not revenues
The whole idea of business is not to "sell more stuff," but to "make more profit off the stuff you sell." Although their methods differ, this is the reason Netflix's main TV rivals -- TV providers like Verizon (NYSE: VZ)DirecTV (NYSE: DTV), and Comcast (Nasdaq: CMCSA) -- are constantly raising prices. Higher prices may deter some customers from signing up for cable. It may perturb other customers so much that they cut the cord. But so long as the customers who remain pay significantly higher prices, the net result is higher profits.

And that's what Netflix needs to do to: earn more profit. From where I sit, the profits Netflix currently earns just don't justify the stock price.

Valuation matters
Valuation, you see, always matters. Absent growth in profits, Netflix's P/E of 71 means it will take a Netflix investor seven decades to recoup the value of today's investment in the stock, from the profits the company earns tomorrow. Heck, even if the company grows at the near-30% annual pace most investors on Wall Street predict, the shares look expensive.

And, of course, there's the free cash flow issue. Between capital spending and the cost of keeping its DVD library stocked, capital expenditures (capex) ate up $175 million of the $285 million cash flow Netflix brought in over the past 12 months, leaving the company with just $110 million in "free," unencumbered cash flow. (If anyone's counting, that gives Netflix a truly obscene price-to-free cash flow ratio of 89.)

Foolish final thought
Now here's the really key point: DVD library costs make up the bulk of Netflix's capex. Reduce or eliminate the need to stock physical DVDs, and Netflix will not only save on shipping costs -- it will cut capex, and expand free cash flow dramatically.

© 2010 UCLICK L.L.C.