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Netflix Rating Cut — Should You Sell NFLX?

Netflix (NFLX) is up more than 200% in the past 12 months and 130% year-to-date in 2013.

Yet analysts at Bernstein Research think the run is overdone, and have given the stock an “underperform” rating with expectations that the stock will slump from more than its current price of roughly $210 a share to $180 in the next year.

So should you sell NFLX stock?

Maybe … If you’ve been holding for several months, it’s prudent to take partial profits and rebalance to other positions to diversify your risk. And if you’re a short-term trader, the mayhem of the past few weeks should give you pause in every corner of the equities market.

But while I see risk for Netflix, I don’t see any true negatives that would change the positive narrative. That can, of course, come from outside factors or from one bad headline a few months from now, but even if that happens, there’s no reason to think Netflix will crash and burn.

First, here are the honest risks as I see them — then the continued bull case for NFLX:

Risks for Netflix Stock

  • Tenuous Growth Hopes: Netflix’s forward P/E is about 80 based on fiscal 2014 projections — pretty high, even for a high-growth tech stock. Netflix has been throwing big money at original content and international expansion, but earnings remain elusive. Remember that the big reason for a gap up in January was that Netflix posted a surprise profit. Great that it achieved breakeven, yes, but that’s hardly an endgame. A lot of growth is left to go.
  • Momentum Moves Both Ways: Brand tarnish after the Qwikster debacle is gone, but the lessons of the crash show that momentum can turn in a hurry. NFLX stock was flirting with $300 in mid-2011 before crashing to about $65 in five months — a cautionary tale if there ever was one.
  • Competition: As a first mover, Netflix has an advantage. But Amazon’s (AMZN) Prime service, Hulu and subscription-based YouTube programming from Google (GOOG), among others, are gaining steam. And remember that entrenched cable companies like Comcast (CMCSA) and Time Warner (TWX) are not thrilled about losing their cash cows and will look to complicate manners wherever they can.

Bull Case for Netflix Stock

  • Scale Matters, Not P/E: It’s not just the surprise profitability from January or recent earnings beats that have investors bullish. It’s the human factor — with Q1 earnings showing more than 30 million streaming customers in the U.S. alone. It’s common to get worked up over the valuation, but consider that Amazon has been boasting a nosebleed P/E for … well, forever. Margins are thin and profits aren’t amazing, but the dramatic scale of the business in an age of growth is more than enough for Wall Street. It should be enough for you, too.
  • Streaming Is Not a Fad: Streaming video use is only going to soar in the coming years, and while Prime and YouTube and Hulu offer options, Netflix doesn’t have to own a massive slice when the pie itself is growing bigger all the time.
  • Content Matters: From original show House of Cards produced in-house to the deal with Disney (DIS) in December to its largest-ever deal with DreamWorks (DWA) just weeks ago, Netflix is serving its viewers by chasing after programming. In the end, that’s how you grow a business — by focusing on your product and your customers. Squeezing margins is good quarter-to-quarter, but long-term growth relies on brand and reach. Barring the aforementioned Qwikster mess, Netflix seems to know this.

There’s no doubt Netflix is frothy and new money might be buying a bit of a top here in the short term. There’s also the risk of short-selling pressure with 20% of the float held by bearish investors.

But there’s also the chance of another double-digit move on an earnings beat and a short squeeze lifting shares.

There’s bound to be volatility, but I think Netflix will hang tough in the near-term and continue to rise over the next few years as it continues a great growth story.

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.

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