Top picks 2012: Netflix

Every once in a while an outstanding company falls from grace. Sometimes it�s that the market for its products has changed. Other times it�s due to external factors such as expiring patents, a lawsuit, an unexpected catastrophic event, or new competition.

And occasionally, it�s just because management screws up. The latter is what has dragged Netflix (NFLX) down over the last five months.

Through a series of self-inflected wounds � namely poor decisions by management � Netflix stock fell a remarkable 77% from its 52-week high of $304. Netflix shares now trade at around $70. But I believe the stock could double in the next six to 12 months.

Netflix is a pioneer in the video rental business. The company invented the DVD-by-mail business, essentially put Blockbuster out of business, and has now expanded into video-on-demand.

In many ways, Netflix is the cable company of the 21st century. At the end of the company�s third quarter, Netflix served 23.8 million subscribers � more than any other U.S. cable or satellite company.
The company�s video streaming accounts for 29% of ALL domestic, peak-hour Internet traffic. YouTube accounts for only 10%. Sounds like a great business, right? So what went wrong?

Starting in July, founder Reed Hastings and his management team made a series of poor decisions that puzzled and infuriated subscribers, increased cancelations, and damaged the good brand image that the company had built since its founding in 1997.

Chronologically, Netflix hiked its prices 60%, tried to spin off its DVD rental business under a new �Qwikster� brand that would have required DVD subscribers to re-subscribe, then canceled its Qwikster plans a few weeks later in the face of substantial subscriber backlash. By October 24, Netflix had lost 805,000 subscribers.

Clearly management screwed up. But at $65-$75 at the moment, there are plenty of reasons to buy such an undervalued stock.

The company is still the clear leader in the online video streaming business. Its many licensing agreements with movie studios and TV networks are still in place.

It still offers a reasonable price. And Netflix is aggressively expanding around the world into places such as Canada and Latin America.

I expect that 12 months from now shares of Netflix will be valued at over $100. Longer term, I think $150 a share is quite reasonable.

This bullish outlook is based on my view that the company will rebuild its brand in the U.S. and gain traction as it expands around the world. While there certainly are concerns, the worst-case scenario appears to be priced into the stock.

Netflix is small enough that it would be an easy acquisition for a larger company that wants to lock up the video streaming business.

While an acquisition doesn�t appear imminent, the potential for one will likely provide a �floor� under Netflix shares. I believe that floor is likely around $60 per share.

With limited downside risk and significant potential for getting things back on track, the risk-reward of Netflix appears incredibly attractive.