The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney, Abbott Laboratories and AbbVie, La Monica does not own positions in any individual stocks.
Netflix stock was hit so hard earlier this year, it made you wonder if billionaire Raymond Tusk from "House of Cards" was shorting it. Or if religious zealot Pennsatucky from "Orange is the New Black" was waging a holy war against the immorality of Netflix's content.
Shares started 2014 just north of $368 and quickly moved to an all-time high of $458 by early March. And then the bottom fell out of momentum stocks.
By late April, Netflix (NFLX) had given back all its gains for the year ... and then some. The stock dipped below $300 in late April. But it's enjoyed an amazing comeback since then. It's now trading at around $424, just 7% below its record high.
So what's next for the stock?
With season 2 of Netflix's dark prison comedy "Orange is the New Black" available for binge watching on Friday, I figured now's a good time to analyze Netflix's valuation and growth prospects. And sprinkle in as many OITNB references as possible. Will Red finally catch the elusive jail yard chicken? She just wants to make a nice Kiev!
Here's the bull case for Netflix -- and bear argument against it.
Why you should buy Netflix
Netflix is aggressively expanding in Europe. That should boost its streaming subscriber base and revenue. According to estimates from FactSet Research, analysts expect international revenue to nearly double this year to $1.3 billion and hit just under $2 billion next year.
The company has also made the leap from being a mere content distribution platform to a true media company thanks to hits like "House of Cards" and "Orange is the New Black."
I am hoping for a very special crossover episode in 2015. Maybe (spoiler alert!) First Lady Claire Underwood visits Piper and her fellow inmates at Litchfield for an inspirational talk?
With Netflix now trading at a market value of about $25 billion, it's not out of the realm of possibility for it to one day be bigger than some of its old media "frenemies." Discovery Communications (DISCA), which owns the Discovery Channel, TLC, and Animal Planet, is worth about $28 billion. And CBS (CBS) has a market cap of $34 billion.
"This is a company right in the thick of things regarding the wave of the future in media," said Bob Bacarella, manager of the Monetta Fund and an owner of Netflix stock.
Bacarella said that as long as Netflix has earnings momentum on its side, he's happy to stick with the stock -- despite a valuation that even OITNB's Suzanne would probably deem a little crazy-eyed.
The stock trades at about 100 times 2014 earnings estimates ... but earnings per share are expected to increase by 122% this year. And Netflix has consistently beat Wall Street's estimates over the past year.
"I try and not worry about earnings multiples with companies like Netflix. I focus on its ability to exceed expectations and Netflix has generally been able to do that," Bacarella said. "But every quarter we hold our breath. This is a cult stock."
Why you should sell Netflix
For what it's worth, some of the so-called smart money is abandoning Netflix. Hedge fund Tiger Global, run by wunderkind Chase Coleman, dumped its entire Netflix stake in the first quarter. So did George Soros. And Carl Icahn continued to trim his position -- as did mutual fund giants Vanguard and T. Rowe Price.
The nosebleed valuation may be a concern to institutions. Then again, Amazon (AMZN) has been pretty much overvalued for its entire existence and that hasn't stopped the stock from continuing to climb. The bigger worry may be that even though growth should be strong this year, there are questions about how sustainable it is.
"Netflix is overpaying for content to drive growth ... but it may not be profitable growth," said Brad Lamensdorf, co-manager of Ranger Bear Equity (HDGE), an actively managed exchange-traded fund that shorts individual stocks and is currently betting against Netflix.
Lamensdorf argues that investors should be more concerned by the steady decline in Netflix's DVD business. Yes, it may no longer be cool to get those red envelopes in the mail. But the DVD unit throws off a lot of cash. Costs are low.
Profit margins for the DVD business were nearly 50% in the first quarter of 2014. The margin for Netflix's U.S. streaming business is half of that.
Lamensdorf also worries that Netflix won't have long-term pricing power as the streaming business becomes more competitive.
He notes that Netflix's recent $1 a month increase for new customers is relatively small ... and he predicts that prices may come down as Amazon and Hulu ramp up their original content and licensing deals with other media companies even more than they are currently.
"When other services get critical mass, they'll be forced to cut subscription rates," he said. "They might as well increase prices now and get the money they can."
Lamensdorf concedes that it is risky to bet against a stock that has so much momentum behind it. But he firmly believes that the stock eventually will disappoint momentum investors one too many times ... and that the company could face a painful transition into a hybrid value/growth stock.
The happy medium
What do I think? Is Netflix a screaming buy at these levels? No. But it's a risky stock to short as well. Betting against Netflix CEO Reed Hastings has not been a good long-term strategy.
I've made the mistake of declaring that the stock was way too overvalued numerous times in the past decade. Heck, investing blog Dividend.com even called a 2003 column I did on the stock a "hilariously wrong" call. Kudos to the author of that article, Jared Cummans, on that. He was right about how wrong I was.
My biggest mistake was harping too much on the sticker shock of Netflix's P/E ratio.
While valuations still matter, so do trends. Unless Netflix finally has a major hiccup that would make investors question whether its best days are behind it, the stock will probably keep climbing. Just don't expect more years like last year -- when Netflix surged nearly 300%.
But speaking of 2003, I'm not the only one who thought the stock may have been frothy back then. Hastings and Netflix CFO David Wells conceded in a letter to shareholders in the third quarter of last year that "some of the euphoria" in the stock last year felt like 2003 all over again.
I guess they were hilariously wrong too.
Reader Comment of the Week! Apple (AAPL) may not have surprised too many investors with its WWDC keynote on Monday. But that didn't stop the peanut gallery on Twitter (of which I consider myself a proud member) from cracking jokes about some of the new features in iOS 8.
I made light of all the apps that had the name Kit at the end and wondered if Apple would launch an homage to the woman who was the best Catwoman ever. One reader went a step further ... and had a brilliant 80s TV reference. He gets bonus points for a dorky Fed-inspired Twitter handle. But what will you do when the Fed is done tapering?
Ha! Don't hassle the Hoff! I guess Apple won't need to buy Tesla (TSLA) if they can pull off KittKit. Love it. And on that note, the Knight Rider theme song.