The Most Surprising Thing About Facebook’s IPO? Trading Has Been Completely Rational!

Today’s Facebook (FB) IPO is the first time I can remember being completely shocked at the lack of trading excitement and volatility for a much-hyped IPO. Ironically, the reason for such unexciting, rational behavior is because of how hyped the Facebook IPO was to begin with. The share allocation to retail investors at the $38 offer price was huge. I put in orders for my larger clients at E*Trade, one of the brokerage firms that got a sizable piece of the IPO, but did not really think they would allocate us any shares (there were reports that Fidelity would not even consider giving out shares to any clients who had less than $500,000 with them). What happened? We got every share we asked for.

With that much hype, especially from the retail side, and with that many investors actually getting 100 or 200 shares, it would be completely rational that, since the supply was very large and the price was fair, a large first day surge would be unwarranted. But we are not used to seeing first day rationality for hot Internet IPOs. In hindsight, it makes sense that Facebook opened at $42.05, only up $4. With so few incremental buyers (given the huge retail allocation at the IPO price), it also makes sense that the stock would see selling at the open, which did occur, sending the stock down to $38 exactly within the first 30 minutes of trading.

So while I am pretty shocked that this IPO has been so calm, I think it bodes well for how the financial market worked. For what could very well be the most hyped IPO ever, investors are acting completely rational and the investment bankers have done a really solid job of not only correctly pricing the deal, but also letting the “Average Joe” participate. The retail brokerage customer won’t be getting rich off of this IPO on day one, but that is not the way it should work anyway. With so many people getting stock, the immediate paper gains should be modest. That is how the marketplace should work. It is all about supply and demand after all.

Full Disclosure: I received Facebook shares at the IPO price, as did a few of my clients. I was planning to look for a chance to flip them today, after a nice pop, but with this interesting trading action to start the day, we have yet to sell a single share as of the time of this post. As always, positions may change at any time.

UPDATE (5/18): I sold my client’s Facebook shares after this post was originally published, in afternoon trading at $40.09 each.

Is Priceline’s Stock Valuation Out of Whack with Reality?

Rob Cox of Reuters Breakingviews was on CNBC this morning sharing his view that the stock of online travel company (PCLN) appears to be dramatically overvalued with a $30 billion equity valuation (even after today’s drop, it’s actually more like $35 billion). Rob concluded that Priceline probably should not be worth more than all of the airlines combined, plus a few hotel companies. While such a valuation may seem excessive to many, not just Rob, it fails to consider the most important thing that dictates company valuations; cash flow. In this area, Priceline is crushing airlines and hotel companies.

As an avid Priceline user, and someone who has made a lot of money on the stock in the past (it is no longer cheap enough for me to own), I think it is important to understand why Priceline is trading at a $35 billion valuation, and why investors are willing to pay such a price. While I do not think the stock is undervalued at current prices, I do not believe it is dramatically overvalued either, given the immense profitability of the company’s business model.

At first glance, Priceline’s $35 billion valuation, at a rather rich eight times trailing revenue, may seem excessive. However, the company is expected to grow revenue by nearly 30% this year, and earnings by 35%, giving the shares a P/E ratio of just 23 on 2012 profit projections. Relative to its growth rate, this valuation is not out of line.

The really impressive aspect of Priceline’s business is its margins. Priceline booked a 32% operating margin last year, versus just 4% for Southwest, probably the best-run domestic airline. With margins that are running 700% higher than the most efficient air carrier, perhaps it is easier to see how Priceline could be worth more than the entire airline industry.

Going one step further, I believe investors really love Priceline’s business because of the free cash flow it generates. Because Priceline operates a very scalable web site, very little in the way of capital expenditures are required to support more reservations and bids being placed by customers. Over the last three years, in fact, free cash flow at Priceline has grown from $500 million (2009) to $1.3 billion (2011). At 27 times free cash flow, Priceline stock is not cheap, but given its 35% earnings growth rate, it is not the overvalued bubble-type tech stock some might believe.

Full Disclosure: No positions in any of the companies mentioned, but positions may change at any time

Tread Carefully, Apparently Another Mini Internet Bubble Is Here

The good news is that we are nowhere near 1999 levels in terms of Internet company hype and excessive valuations. The bad news is that we are seeing the same types of froth, just to a lesser degree, that we saw back then. More than a decade ago we were wondering how Yahoo (YHOO) was worth more than Disney (DIS) and the market eventually corrected that inefficiency (today’s values: Disney $76B, Yahoo $18B). Today we see online gaming company Zynga (ZNGA) worth $8 billion ($1 billion in annual revenue) compared with a value of $5 billion for Electronic Arts (EA) ($4 billion in annual revenue). Monster Worldwide (MWW) has $1 billion in sales and a $1 billion equity valuation, versus LinkedIn (LNKD) which has similar revenue and a $10 billion market value. These figures are lopsided in percentage terms, but at least these Internet stocks aren’t worth more than the country’s bluest of blue chips.

Facebook’s $1 billion deal this week to buy Instagram, a mobile photo service with no revenue, shines a light on another phenomenon that we saw during the last bubble; huge changes in valuations one day to the next without any change in business fundamentals. In the 1990’s a company could issue a press release announcing they were going to launch a web site and the stock would pop 50 or 100 percent. The Facebook deal is not astonishing as much for its price tag as it is for the fact that just last week Instagram raised $50 million in venture capital money at a valuation of $500 million. In a few days, Instagram’s value doubled to $1 billion without it doing anything on the business side to warrant that price. Can you imagine how giddy the VC folks who made that deal must be? It’s almost unbelievable.

To put the $1 billion price in perspective, consider than Instagram has 30 million registered users who pay nothing. Facebook is paying more than $300 $30 per user for the company. Facebook itself has about 850 million users and netted $3 billion in revenue from them last year. At the forthcoming IPO valuation of $100 billion, Facebook is being valued at just over $100 per user. Should an three Instagram users be worth three times that of a the same as one Facebook user? It’s hard to see how. Now, I understand that Facebook is paying a premium to buy the company outright, so these per-user numbers are skewed by that fact, but still, it’s the general trend of the numbers that seems unsettling.

Overall, the U.S. stock market has more than doubled from its 2009 low. The IPO market has been on fire lately and these Internet stock valuations certainly are pointing to the strong possibility that we have a mini bubble yet again. While I would never predict we will see a repeat of 1999, I do think market participants need to tread carefully with these new companies. The current environment might indicate that at least a certain part of the equity market is overheating.

Full Disclosure: No positions in any of the stocks mentioned, but positions may change at any time

My Aversion to Semiconductor Stocks Explained

I recently took over an existing stock portfolio for a new client and proceeded to liquidate a small cap, Taiwanese semiconductor company in favor of other tech stocks I preferred. Since the sale the stock has risen about 10% and the client emailed me wondering why I sold and what my outlook on the little company was. My answer was not as company-specific as it could have been (I knew very little about it and instead preferred to avoid small, non-U.S. chip stocks in favor of other stocks I have spent hours researching), but I did admit that I have an aversion to semiconductor stocks in general (although exceptions sometimes do present themselves).

I find the semiconductor space quite difficult to analyze and even harder to make money in as a long term investor. The industry is very cyclical, certain chips are always being replaced by a next generation product (often from a competitor), and with such high fixed costs required to manufacture chips, profit margins often rise and fall like roller coasters, making for a very volatile stock price environment. Even when you can identify solid semiconductor companies with below-average competition, in growing markets, making money on their stocks can prove quite difficult.

For example, consider flash memory manufacturer SanDisk (SNDK), a current favorite of many hedge fund managers. SNDK is a good company and with demand for flash memory soaring in recent years due to increased penetration of consumer electronics products, sales have been going through the roof. Over the last five years, in fact, SanDisk has seen its annual revenue grow more than 70% from $3.2 billion to $5.6 billion. It would be logical to assume that SNDK stock has been a great investment over that period, but you might be surprised to learn that five years ago today the shares closed at $44.50 each. Yesterday’s closing price was $44.51 per share. I know this is only one example, but chip stocks can be tough nuts to crack from an investment standpoint.

In SanDisk’s case they actually have done a great job at maintaining their strong position in the flash memory market, as opposed to many chip companies who often find themselves supplying Apple with a chip for one iPod only to see them be cut out of the next generation product in favor of a competing chip. The problem that SanDisk faces, as do most in the sector, is falling prices. If you have bought your fair share of memory cards, you know that every year prices drop. You can either buy the same amount of memory a year later for much less money, or you can spend the same and get a much larger card. There is no pricing power in the industry, which is great for consumers but not good for investors.

The problem is that huge demand and the corresponding unit growth that comes with it can often largely be eaten away by price erosion. Consider a market where prices drop 30% year-over-year for the same chip (not uncommon if you ever shop for digital camera memory cards and similar products). In order to keep your revenue in dollar terms steady, you need to grow units 43% per year. If you want to grow revenue, say 15%, over the prior year, you need to ship 64% more units! SanDisk actually has been fortunate that demand for flash memory has been so strong, as other areas within the chip space have not been nearly as robust.

So while I agree with many smart money managers who have been accumulating the stock that SanDisk is a good company that is serving a growth market, and that its stock does appear to be cheap, I do not share the same optimism about its long term prospects as an investment. It is just really hard to sustain stock price appreciation in an industry with these types of market dynamics. While there are certainly plenty of success stories within the semiconductor stock universe, I suspect for every long term stock market winner there are five or ten big losers, and I personally do not care for those kinds of odds.

Full Disclosure: No position in SNDK but positions may change at any time

Apple Stock Hitting New Highs: Where To From Here?

It has been a little over a year since I wrote that Apple Stock Can Easily Reach $450 last January, which at the time was more than $100 above where the shares were trading. Thanks to an absolutely stunning fourth quarter earnings report, Apple pierced that level late last month and closed yesterday at a new high of $464 per share. So, where to from here?

The company continues to defy expectations on the profit front, and after crushing numbers for the holiday quarter, analysts now expect $42 of earnings per share in fiscal 2012, up from just a $35 consensus figure a few weeks ago. In addition, cash continues to build on the balance sheet, reaching $98 billion at year-end, up 50% from a year ago.

An interesting thing has happened with the stock, though. As management has continued to hoard cash unnecessarily, and the company reaches a size that many believe makes it prone to a stumble in the not-too-distant future (investors expect this $100 billion a year company to grow 45% this year), the P/E ratio of the stock has tumbled. In fact, Apple now trades at a discount to the S&P 500 index on a trailing earnings basis (13x vs 14x). Looking out at 2012 profit expectations, the gap widens further as Apple’s P/E drops to about 11x. And that does not even include the $100 per share of cash Apple is sitting on.

As far as the cash goes, Apple is essentially getting no credit for it in the public market. The stock trades for about 8.7 times 2012 earnings ex-cash, which tells me that if they did pay a huge one-time special dividend ($50 per share would be my recommendation, not that anyone has come asking), the stock would likely not drop as would be the case in most similar instances (doing so would mean the discount to the market would get even larger). This is one of the reasons I am not selling Apple shares yet.

In terms of earnings, it appears that the days of Apple commanding a premium in the market are behind us. Even with a ridiculously positive earnings surprise for the fourth quarter, Apple stock popped just 6%. That compares with an earnings beat of 35% and an upward revision for 2012 profits of some 20%. Given Apple’s size, extreme bullish sentiment, and awful capital allocation practices, investors are not going to give them a rich valuation, which limits upside to a certain degree by taking multiple expansion off the table.

Given these new parameters, how can we value the darn thing? First, I will assume they do not change their cash management strategy this year (a painful thought). Since I do not see the market giving Apple more than a market multiple, I would multiply $42 in earnings for fiscal 2012 by 13 (market P/E) and that gets us to $546 per share. There are plenty of Wall Street analysts with year-end price targets that have a six in front of them, but I just do not see that happening. So, my best case guess is 17-18% upside from here, and maybe a bit more if Tim Cook eases up the company’s death grip on their cash. As a result, I am not a seller yet, even though the stock reached my $450 target price from last year.

Full Disclosure: Long shares of Apple at the time of writing, but positions may change at any time.

More on Netflix’s Valuation and How the CEO Doesn’t Own a Single Share

Netflix (NFLX) CEO Reed Hastings has certainly done a wonderful job running the company if you look at his entire body of work, despite recent slip-ups, but his handling of the stock leaves much to be desired. Buying back stock over $200 per share only to raise capital at 1/3 the price a few months later shows he is losing the pulse of his business, at least temporarily.

So exactly how much stock of his own company does Hastings own? Believe it or not, none. Hastings has been cashing out Netflix stock options to the tune of tens of millions of dollars, but he does not actually own a single share. This year alone he exercised options (strike price: $1.50) to the tune of over $1 million per week, or more than $43 million. He halted those sales in early October after the stock cratered. It should be troubling to investors that the company’s founder and CEO does not appear to have any real skin in the game here. He has just given himself millions of options at prices that essentially ensure he can continue to cash out at will as long as the stock stays above $1.50 per share, which is assured as long as the company remains in business.

All of that said, there does appear to be potential value here with the stock breaking $70 per share, providing Hastings can make the streaming business model work financially. Netflix’s enterprise value today (about $4 billion) is attractive if the company can continue to grow and make money at their $8 per month price point. Assume for a moment that Netflix can earn a net profit of $1 per subscriber per month and maintains its current base of 25 million customers. That comes out to a profit of $300 million per year. Netflix could fetch a $4 billion valuation with its existing customer base alone. Any further subscriber growth from here would be icing on the cake for investors.

I think that is the main reason why T Rowe Price, TCV, and others find the stock attractive at current prices. There are definitely sizable risks, mostly the question of whether they can continue to grow with intense competition, and even more importantly, if the company’s business model will allow it to reach something on the order of that $1 per month profit on a per-subscriber basis. Given all that we know today, Netflix is a high risk, high reward investment opportunity, but one that many people are betting on.

Full Disclosure: No position in Netflix at the time of writing, but positions may change at any time

Netflix Makes New Moves to Try and Regain Momentum

Shares of Netflix (NFLX) are getting slammed today (down $4 to $70) after announcing $400 million of financing transactions last night, consisting of $200 million in new equity at $70 per share to T Rowe Price and $200 million in convertible zero-coupon bonds to venture capital firm Technology Crossover Ventures. This move comes on the heels of the company’s recent deal to be the exclusive home to new episodes of the comedy series Arrested Development, which was canceled after a three-year run on Fox despite a cult-like following and strong critical acclaim.

Netflix may be facing headwinds after customer backlash from their recent price increase, but CEO Reed Hastings is certainly not standing still. Getting the exclusive for Arrested Development is a smart move, as it will be harder and harder for Netflix to compete strongly without original, unique content. Amazon, which offers a similar streaming service through Amazon Prime, along with Apple, which will likely launch a TV product sometime in 2012, are serious competitors to the Netflix streaming business.

While Wall Street clearly does not like these equity and bond deals, I think it is really the best possible way for them to finance the costs of deals like Arrested Development. Selling zero-coupon bonds gives Netflix 0% financing and the bonds don’t convert until 2018, which is a long time for Netflix to build up their business.

I would also point out that TCV, the investor in this bond deal, is making an interesting bet here. By taking convertible bonds that pay no interest, they are making a large bet on the direction of Netflix stock, plain and simple. TCV’s break-even point on these bonds is $86 per share, 16% above the market price when the deal was announced and more than 20% above the current quote of around $70 per share. While investors are selling off the stock today, the fact that TCV is making a pure stock bet here could be viewed as quite bullish (as would the move by T Rowe to buy new stock at $70). If Netflix was really in dire need of this cash and few investors were willing to lend it to them, you can bet that TCV or any other possible financier would be demanding a bulky interest rate.

With Netflix stock down more than 75% from its high of $300+ earlier this year, this one is surely one to watch. Of course, it is very concerning that Netflix was buying back stock in the 200’s earlier this year and now finds itself needing money and selling new stock at $70 per share. Investors likely won’t tolerate this “buying high and selling low” set of actions again down the road. The future for Netflix really depends on whether they can continue to grow the streaming business and make money on it at $8 per month. If they can, there is plenty of upside here. If not, TCV and T Rowe are going to have some losses on their hands a year or two from now.

Full Disclosure: Long Apple and no positions in Amazon or Netflix at the time of writing, but positions may change at any time

Numbers Behind Groupon’s Business Warrant Caution After First Day Pop

Daily deal leader Groupon (GRPN) is slated to go public today, selling 34.5 million shares at $20 each, which will raise $690 million in exchange for a 5.4% stake in the company. Combine a popular Internet start-up with a very low number of shares being offered (floating 5% of all shares is historically a very small IPO) and demand will far outstrip supply. We may not see a record setting first day pop, given the eleven-figure starting valuation, but the stage will be set for a solid jump at the open on Friday. And even without any first day gain, Groupon will be valued at about $12.75 billion.

As one of Groupon’s 16 million repeat customers, I was interested to dig into their IPO prospectus because I have already seen my use of Groupon decline meaningfully since I signed up to receive their daily deal emails last year. To me, Groupon has several headwinds facing their core business.

First, Groupon is dealing with many small business merchants who complain that they lose money when running a Groupon campaign. If businesses really see Groupons as a way to mint money immediately, they are mistaken about what role the deal campaign should play. A Groupon deal should be viewed as a marketing expense, not a profit center. A business should use Groupons to get prospective customers in the door. After that, just like any other marketing tool, it is the business’s job to treat them well and provide a good service, which should encourage repeat business. It will be those recurring customers that will grow your business long term and generate profits.

Generally speaking, profit margins for small businesses are hardly ever high enough to make a 50% discounted transaction profitable to the business. If you offer $50.00 Groupons for $25.00 each and only keep $12.50 per voucher (Groupon keeps the other half), the odds are slim you will make a profit initially. Unless it only costs you no more than $12.50 to offer $50.00 in goods or services, you are going to lose money. Let’s say you lose $20.00 per Groupon in this case. The real question should be, is a new customer coming through your doors worth $20 to you? The only way to answer that is to look at other marketing options you have. Do they cost more or less than $20.00 per new customer generated? If the answer is more, then Groupon is a worthwhile way to market to prospective new customers.

Along the same lines, I think Groupon will struggle once they have exhausted most of their small business merchants in any given city. As the example above shows, Groupons themselves are not money makers, which makes it less likely that a small business is going to want to run multiple campaigns. As a result, when you run out of businesses, your deal quality declines and fewer Groupons are going to sell. Groupon is probably facing these issues today, as the business is three years old and many businesses have already used the service. It is my belief that new businesses should probably strongly consider running a Groupon campaign, given that the biggest obstacle for new businesses is lack of awareness. But honestly, there are not likely enough new businesses cropping up to support strong long-term growth of Groupon’s core daily deals business. As a result, merchant growth could very well hit a wall sooner rather than later.

Groupon’s IPO prospectus provided a lot of data that investors may want to use to try and value the company. For instance, as of September 30th, Groupon had 143 million email subscribers. How many of those have ever bought a Groupon? I was pretty surprised by this number actually… the answer is 30 million. Only 20% of the people getting these emails have ever bought one, and that is a cumulative figure for the last three years! Investors trying to place a value on Groupon’s subscribers may want to forget the 143 million number, as only 30 million are generating revenue for the company.

The numbers get worse. Of those 30 million people who have bought at least one Groupon (Groupon calls them “customers” as opposed to the 143 million “subscribers”), only 16 million are repeat customers. So only about 10% of the people who get the emails have bought 2 or more Groupons since the company launched. This is hardly a metric that screams “loyal customers that generate strong repeat business,” which is what investors would want to see.

Why is this important? I think a good way to try and value Groupon (if you even want to bother) is to place a dollar value on each paying customer. After all, Groupon is not unlike a subscription service like Netflix or Sirius XM Radio, aside from the obvious fact that a paying customer of the latter two businesses are more valuable because they generate guaranteed revenue each and every month. In fact, both Netflix and Sirius get about $11.50 per month on average from their paying customers. Interestingly, Groupon earns about $11.90 in revenue for each Groupon it sells, but they are not even close to selling every customer at least one Groupon per month on a recurring basis. As a result, it is correct to conclude that investors should value a Groupon customer far below that of a Netflix or Sirius customer.

Which brings us to the stock market’s valuation of Groupon versus Netflix or Sirius. Each of Netflix’s 23 million subscribers are worth about $200 based on current stock prices. Sirius XM, with 21 million subscribers, is valued at about $600 per subscriber (considerably more than Netflix because Sirius XM has higher profit margins). How much is the market paying for each Groupon customer at the $20.00 per share IPO price? Well, $12.75 billion divided by 30 million comes out to $425 each.

It is not hard to understand why skeptics do not believe Groupon is worth nearly $13 billion today. To warrant a $425 per customer valuation, Groupon would have to sell far more Groupons to its customers than it does now, or make so much profit on each one that it negates the lower sales rate. The former scenario is unlikely to materialize as merchant growth slows. The latter could improve when the company stops spending so much money on marketing (currently more than half of net revenue is allocated there), but who knows when that will happen or how the daily deal industry landscape will evolve in the meantime over the next couple of years.

“Buyer beware” seems to definitely be warranted here.

***Update Fri 11/04/11 8:55am*** Groupon has increased the number of shares it will sell in today’s IPO to 40.25 million from 34.5 million. The figures in the above blog post have not been adjusted to account for this increased deal size.

Full Disclosure: No positions in any of the companies mentioned at the time of writing, but positions may change at any time

Sticking To Your Convictions As A Value Investor Is Hard, Just Ask Whitney Tilson About Netflix

Back in December, Whitney Tilson, a fairly well known value investor with T2 Partners, published a letter outlining a compelling bear case for Netflix (NFLX), a stock he was shorting at around $180 per share. After seeing the position go against him, Tilson was feeling pressure from his clients. After all, shorting a high-flying technology company with a cult-like following, as it is soaring in value, can be a tough psychological exercise. Tilson’s argument for betting against Netflix was clear, concise, and thorough. He boiled it down to this, in his December piece entitled Why We’re Short Netflix:

“We don’t think there are any easy answers for Netflix. It is already having to pay much more for streaming content and may soon have to pay for bandwidth usage as well, which will result in both margin compression (Netflix’s margins are currently double Amazon’s) and also increased prices to its customers, which will slow growth.

Under this scenario, Netflix will continue to be a profitable and growing company, but not nearly profitable and rapidly growing enough to justify today’s stock price, which is why we believe it will fall dramatically over the next year.”

The main bearish argument seemed reasonable at the time; customers were moving away from DVD by mail and towards streaming content. In order to secure content for their streaming library, Netflix would have to pay more than in the past, when they could just buy a DVD once and send it out to dozens of customers. But at the time subscribers were signing up at a record pace and were highly satisfied.

In February Tilson threw in the towel. The stock had continued its ascent, rising to $220. Again, Tilson went public with his changed view, writing a letter called Why We Covered Our Netflix Short. The bulls loved the fact that Tilson was admitting defeat. The stock continued soaring and hit an all-time high of $304 in July. Tilson summed up his reasoning as follows:

Our short thesis was predicated on the following stream of logic:

1) Netflix’s future depends on its streaming video business (rather than its traditional DVD-by-mail business);

2) The company’s streaming library is weak, which would lead to customer dissatisfaction and declining usage;

3) This would either cause subscriber growth to wither or force Netflix to pay large amounts to license more content, which would compress margins and profits;

4) Either of these two outcomes would crush the share price.

We are no longer convinced that #2 and #3 are true.

This was interesting because very little in the way of fundamentals had changed at that time. Tilson cited three reasons why he was doubting his earlier bearish thesis:

1) The company reported a very strong quarter that weakened key pillars of our investment thesis, especially as it relates to margins;

2) We conducted a survey, completed by more than 500 Netflix subscribers, that showed significantly higher satisfaction with and usage of Netflix’s streaming service than we anticipated (the results of our survey are posted; and 

3) Our article generated a great deal of feedback, including an open letter from Netflix’s CEO, Reed Hastings, some of which caused us to question a number of our assumptions.

In hindsight these reasons seem even more suspect than they did at the time, but it is worth pointing out the mistakes anyway so value investors can learn from each other.

First, Tilson cited that Netflix reported a strong fourth quarter. Tilson’s bearish view was never predicated on Netflix blowing the next quarter. It was the longer term trend of rising content costs, which would give Netflix two choices; maintain a weak streaming library and risk losing customers, or pay up for strong content and be forced to either raise prices (which would hurt subscriber growth and reduce profitability) or keep prices steady and lose profitability that way. The fact that Netflix reported one strong quarter really didn’t make a dent in the bearish thesis.

Second, Tilson surveyed 500 Netflix customers and found they were quite happy with the service. Again, his thesis didn’t claim that current customers were unhappy (after all, they were signing up in droves in part because streaming was free with your subscription at the time). Rather, it was about the future and how those customers would react if Netflix had to either raise prices or offer less in the way of viewing choices.

Third, and this one was perhaps the most bizarre, Tilson was evidently persuaded by Netflix’s own CEO, Reed Hastings. I find this one odd because I have never seen a CEO on TV or elsewhere who was publicly negative about their company’s prospects, regardless of how good or bad things were going at the time. In fact, many investors believe it is a huge red flag when CEOs of public companies take time to personally rebuff bearish claims from short sellers. Hastings did just that, responding to Tilson’s short case with a letter of his own that suggested that he cover his short immediately. Generally speaking, the fact that the CEO of a company you are short thinks you are wrong is not a good reason to cover your short.

And so we had a situation where Tilson’s short thesis appeared sound, albeit unresolved, but the stock price kept soaring and he was feeling heat for the position, which was losing money. Then, just a few months later, Netflix decided to raise their prices and customers canceled in droves. Tilson’s bearish thesis proved exactly correct, but he no longer had the short bet to capitalize on it.

Today in pre-market trading Netflix stock is down about 30% to $83 per share after forecasting higher than expected customer cancellations, lower than expected fourth quarter profits, and operating losses during the first half of 2012 due to higher content costs, slowing subscriber growth, and expenses for the company’s expansion into the U.K. and Ireland. Analysts were expecting Netflix to earn $6 per share in 2012 and in July investors were willing to pay 50 times that figure for the stock. Now it is unclear if Netflix will even be profitable in 2012 after forecasting losses for the first “few quarters” of next year.

This is a perfect example of why value investing is a tougher investment strategy to implement than many realize, but offers tremendous opportunity to outperform. By definition you have to take a contrarian view; either going long a stock that people don’t like, or shorting a stock that everyone loves. The bottom line is that your analysis is what is important. If you do your homework and get it right, the market will reward you. It may take more than a quarter or two, but you need to stick to your convictions unless there is extremely solid evidence that you are wrong. In this case, Tilson’s bearish thesis was never really debunked by the CEO’s defensive posture or the fact that customers were satisfied when they were getting streaming content for free. In hindsight, Tilson understood the outlook for Netflix better than the company’s own CEO. However, both are likely feeling very uneasy this morning.

Interestingly, the question now may be whether there is a point at which Netflix stock becomes too cheap and warrants consideration on the long side. I suspect the answer is yes, though probably not quite yet. If the stock keeps falling and we see $60 or $70 per share, maybe the time will be right for value investors like Tilson to go against the crowd again and buy the stock when everybody hates it.

Full Disclosure: No position in Netflix at the time of writing, but positions may change at any time

UPDATE: 3:00PM ET on 10/25

The WSJ is reporting that Tilson initiated a small long position in Netflix this morning:

Mr. Tilson tells us in an e-mail that he bought the stock this morning after it tumbled 35%:

“It’s been frustrating to see our original investment thesis validated, yet not profit from it. It certainly highlights the importance of getting the timing right and maintaining your conviction even when the market moves against you. The core of our short thesis was always Netflix’s high valuation. In light of the stock’s collapse, we now think it’s cheap and today established a small long position. We hope it gets cheaper so we can add to it.”

Dell: The Anti-Hewlett-Packard?

Following up to yesterday’s post on the outright ridiculous valuation being assigned to shares of Hewlett-Packard (HPQ) these days, it is worth playing devil’s advocate and exploring the merits of anti-H-P plays if you believe they will have a hard time convincing its customers that it finally is on the right track. Dell (DELL) should be the primary beneficiary if enterprise customers seek out new vendors, so it would be a perfect way to play the continued demise of H-P.

How does that stock look? Very, very cheap. At $14 per share, Dell fetches about 8 times earnings. But if you dig deeper the stock is even cheaper. Dell has about $10 billion of net cash on the balance sheet, which equates to $5 per share. So investors are really only paying about $9 a share for Dell’s operations, which generate north of $60 billion in annual revenue. With about $5.5 billion in trailing twelve-month EBITDA and an enterprise value of about $16.5 billion, Dell currently trades at 3 times cash flow. Heck, that is not that much more than H-P (2.5 times). Both of these stocks may make a lot of sense at current prices.

Full Disclosure: Long shares of HPQ at the time of writing but positions may change at any time