What Netflix, Inc. (NFLX) Investors Need To Ask

On a regular basis I re-read “Beating The Street” and “One Up On Wall Street” by Peter Lynch. In these two books, Lynch gives individual investors a crash course on how to pick stocks, and also talks about problems that have hindered companies in his experience. One comment he makes is, a high P/E ratio may not keep a stock from doing well, but it can act as a weight that can drag the shares down. With Netflix, Inc. (NASDAQ:NFLX) trading for over 175 times projected earnings, this weight is heavy. In addition, there are five questions that need answers if investors are going to continue to hold the stock.

The coming inflection point
An inflection point is when some dramatic change happens. A company that has been growing earnings by 20% or 30% a year all of a sudden hits the proverbial wall and becomes a 5% to 10% growth story. In Netflix, Inc. (NASDAQ:NFLX)’s case, there are two inflection points that investors need to understand are inevitable in this business.

The first question Netflix investors need to ask is, at what point does size become an issue? There are signs that size may already be a problem. With over 30 million subscribers, Netflix may reach saturation in the domestic market faster than investors realize. According to Bernstein Research’s Carlos Kirjner, the stock market might be expecting 50 million domestic subscribers by 2020 for Netflix, Inc. (NASDAQ:NFLX), but by his research 43 million looks like a more realistic number.

Bernstein expects about 90 million U.S. households with streaming capabilities by 2020. However, only about 70% will have Internet connected televisions and would constitute Netflix’s addressable market. If the company captures roughly 60% of this market, they would have about 42 million subscribers.

According to the same analyst, Amazon.com, Inc. (NASDAQ:AMZN) Prime already has about 3 million members that use Prime Instant Video as their primary streaming service. Based on the growing popularity of Amazon.com, Inc. (NASDAQ:AMZN)’s service, it’s no sure bet that Netflix, Inc. (NASDAQ:NFLX) will capture 60% of its addressable market. When you add in the risk from services like Hulu, and new entrants like Outwall’s Redbox Instant service, this 60% penetration rate becomes even more difficult to believe.

Competition that is far stronger than before
The second question facing Netflix investors is, at what point does new content not bring enough new subscribers to offset the cost? In today’s market new content deals drive the stock price, as reported recently by Fool.com’s contributor Adam Levine-Weinberg. He mentioned that a new deal recently signed by Netflix, Inc. (NASDAQ:NFLX) drove the stock price up 7%. The problem is, while the new content is attractive, Netflix doesn’t release the cost of the content for competitive reasons. This means it’s a mystery if Netflix got a good deal or overpaid.

This leads us to the third question investors need to ask, how can they be sure Netflix isn’t overpaying for content? For point of comparison, Amazon.com, Inc. (NASDAQ:AMZN) has about $4.8 billion in net cash and investments waiting to be used for content creation and acquisition. The previously mentioned Redbox Instant is backed by Verizon Communications Inc. (NYSE:VZ), and they generate about $4 to $6 billion in free cash flow every quarter. Verizon Communications Inc. (NYSE:VZ) also has about 90 million wireless subscribers, and honestly the company has the firepower to blow Netflix, Inc. (NASDAQ:NFLX) out of the water if it comes down to a bidding war.