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Netflix Keeps Defying the Naysayers

The stock isn't cheap, but subscriber growth is trumping a drop in cash flow

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This is the thing about culture wars. Both sides make up their minds early on and quickly dig in for the long term. After a while, they stop listening to each other. Then their words inflame each other. Eventually, reality takes a back seat to the shrill debate.

The culture war I’m talking about has nothing to do with the political landscape, but rather the increasingly profitable corner of culture that involves watching movies online — which is to say, the company now making a tidy profit on that corner: Netflix (NASDAQ:NFLX).

A few weeks ago, analysts were expressing concern that Netflix’s ambitious plans to expand its video library would weigh down margins. Many approached its fourth-quarter earnings to yield evidence that licensing fees would expand just as subscription growth would begin to slow.

But like a well-plotted thriller that became a surprise hit, Netflix posted so-so earnings followed with guidance for the current quarter that was so strong it that pushed the stock 32% higher over the last three weeks.

The surprise left analysts and investors — who had been so confident about the challenges facing the company — scratching their heads. Several analysts raised their ratings on the stock and others upped their price targets. And Whitney Tilson, whose arguments for shorting Netflix were so detailed they drew a response from CEO Reed Hastings, threw in the towel and covered his short position.

This was the opposite of a cliffhanger, it was more like a hero rocketing from the bottom of a dark valley to the top of a cliff’s edge. Once again, Netflix had vanquished the naysayers. And the world was once again safe for its growing herd of bulls.

But if analysts are caving in to the Netflix growth story, the hardcore bears are not content to merely stay bearish – they are also growing more vocal. Since the company’s fourth-quarter earnings, the bulk of the analysis on SeekingAlpha — a community of often but not always thoughtful DIY stock analysis — is weighed strongly against Netflix’s bright future.

The bears cite many negative factors, most of them surrounding the twin threats of rising licensing fees and declining subscriptions. But one big thread running through their arguments involves operating cash flows, which fell 8.6% in the most recent quarter to $96.7 million. For all of 2010, operating cash flows fell 15% to $276.4 million.

Cash flows are essential to a company like Netflix, which must rely on cash to transition from a dying revenue stream (DVDs by mail) to a growing one (streaming videos). And of course the biggest drain on cash flows came from the cost of acquisitions for its streaming content library, which ballooned to $406 million in 2010 from $64 million in 2009.

This is indeed enough to set off alarms of prudent value investors. But there are exceptions to the rule, and one is when investments that are draining cash flows show early signs of paying off. For now, Netflix is showing such signs.

Netflix added 7.7 million net subscribers last year, more than double the 3.6 million it had predicted. A year earlier, Netflix added 2.9 million net subscribers, which was an increase of 1 milion over the 2008 figure. Something Netflix is doing is bringing in a lot of new subscribers.

Article printed from InvestorPlace Media,

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