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Netflix: A star is born ... as a value stock

The risk with the superstar growth stocks – the priciest of pricey – is how quickly and painfully things can go wrong.

Such as with Netflix , which is now down a shocking 70 per cent from its 52-week high of under four months ago. The company's move to split its business angered a heretofore exceptionally loyal customer base, prompting a wave of cancellations. To compensate, management is plowing ahead with an expensive expansion into the United Kingdom, potentially wiping out 2012 profits.

The result? Netflix's trailing price-to-earnings ratio, above 85 at its high on July 13, is now below 20. This gives investors who love the Netflix franchise, but hated the stock's valuation an excellent opportunity to buy.

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But be forewarned: It isn't necessarily all up from here. A further attitude adjustment from Netflix management is necessary.

In a way, the missteps by Netflix and its CEO Reed Hastings aren't surprising given the company's innovative edge. Mr. Hastings' idea to rent DVDs by mail decimated an entire industry of brick-and-mortar retailers; the business of streaming those movies and TV shows via broadband connections threatens to make the original Netflix business model obsolete.

So when Netflix first proposed raising the price of a combination mail-and-streaming subscription by 60 per cent – then announced it would split off its DVD operation entirely under the silly name "Qwikster," it seemed to be a case of Mr. Hastings moving quickly to cast off a declining business model.

In all likelihood, the desire to provide gaudy growth drove that decision. The bad news for shareholders is that in the short term, despite the reversal of the split-up plans, Netflix says it will continue to pursue top-line gains at the expense of profitability.

The company, in its most recent earnings call, said it expects net losses for "a few quarters" as it executes its expansion into the highly competitive U.K. As Goldman Sachs analyst Ingrid Chung put it politely, "visibility into Netflix's earnings trajectory has deteriorated."

Says analyst Michael Pachter of Wedbush Securities, who has a "hold" rating and $82.50 (U.S.) target price on the shares: "It appears that Netflix management is resolute in its desire to grow subscribers in 2012 at the expense of profitability, clearly believing that Netflix remains a 'subscriber growth' story to investors. We disagree, and believe that the precipitous decline in share price reflects a shift in investor focus, with remaining investors focused on profitability."

The good news, notes Mr. Pachter, is that Netflix management can reverse course on the expensive international expansion if it realizes its mistake. "We are not ready to give up on Netflix," he says. "Management has shown brilliance to the point of genius repeatedly in the past, and we think that the recent missteps are in reaction to rapidly increasing content costs. While we never believed that Netflix could earn the $15 to $20 per share that its $300 share price implied, we always believed that the company could continue to grow both its subscriber base and its profits by managing spending as it had in the past."

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The threat that overhangs Netflix is the one-two whammy of high costs for streaming content and who, exactly will compete with the company. Apple, Google and Microsoft, to name three, have cash positions that dwarf Netflix's. Cable companies, which already partner with content creators and typically offer the high-speed connections Netflix requires, pose another potential threat.

In short, the days of rocket-like growth and simultaneously expanding margins – and the 80 P/E that comes with them – may never come again. Yet the company still has 25 million subscribers; the broadest, deepest library of content; and the ability, as long as it wishes, to deliver it via DVD or stream. Despite the recent fumbles, it is Netflix's game to lose, and we are far, far away from the company's end.

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