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

Hewlett-Packard Revisited: Lowest Tech Valuation in 20 Years

You can bet that there will be a Harvard Business School case study written about the last year in the board room at PC hardware giant Hewlett-Packard (HPQ). A little over a year ago I wrote that I thought the stock was pretty cheap after falling to $38 from a high of $55 per share. Mark Hurd, a cost-cutting guru praised by investors, had just been fired as CEO and the company later filled that position with Leo Apothekar, the former CEO of software-focused SAP, a job he held for about seven months before being ousted. At the time Wall Street was reeling from Hurd’s exit and given that H-P is the largest hardware company in the world, most everyone wondered why the Board hired Apothekar of all people. At $38 each, the stock fetched only 8.4 times earnings per share of $4.50, about as low as large tech company valuations ever get. Sure, Apothekar was unproven and hardly an inspiring hire, but unless the company’s business really was about to fall off a cliff, there appeared to be minimal downside risk given the single-digit multiple. Or so it seemed.

Here we are a year later and the H-P story has been downright bizarre. Apothekar was fired last night and replaced by former eBay CEO Meg Whitman. If you thought hiring Apothekar, a software guy, was an odd choice for the world’s leading hardware company, Whitman’s career experiences at eBay, Hasbro, Proctor and Gamble, Disney, Stride Rite, and FTD.com is certainly questionable. Not surprisingly, H-P stock fetches $22 today, the lowest level since 2005 and less than five times earnings. According to an analyst that covers H-P who was on CNBC this morning, a large cap tech stock has not traded at that price in more than two decades.

From an investor’s perspective, the most interesting thing is that H-P’s business has not actually fallen apart, as the stock price would have you believe. Earnings per share for the current fiscal year will likely grow about 5% to $4.80, on flat revenue. So while large technology companies never usually trade for less than 7-8 times earnings, today Hewlett-Packard trades at 4.6 times earnings, which is simply unheard of. To me, that doesn’t make any sense unless H-P’s business crashes. And if that didn’t happen over the last year, I am not sure it is a wise bet that it will happen now. After all, Apothekar’s strategic decisions seem to be correct (focus on growing software and services, dump unprofitable tablet hardware that is bleeding hundreds of millions of dollars, etc), even when the leadership and communication to Wall Street and customers was unclear, inconsistent, and confusing.

So where do I stand on Hewlett-Packard stock now, with clients sitting on a loss over the last year? Given that the company remains a major player that is extremely profitable and trades at a valuation not seen in decades in the technology space, I am strongly considering doubling down here. There may not be many catalysts short term to get the stock higher, unless Whitman was to inject strong leadership and clear priorities quickly, but earnings would have to collapse from here to justify anything near a $22 stock price longer term. The selling pressure in recent months appears to be capitulation from investors who are fed up with the sheer incompetence of the prior board of directors, rather than significant weakness in the underlying businesses at H-P.

Assuming that management can’t get much worse going forward (seems reasonable), there is little reason to think H-P won’t fetch at least a 7-8 P/E in the intermediate term (a higher multiple is certainly possible — the stock fetched 10 times earnings under Hurd — but at this point conservative assumptions seem prudent). That would imply significant share price upside even without earnings growth (though I do think EPS growth is coming — it will be +5% this year even after all that has happened). There are just too many ways to get a higher stock price from here, even without making optimistic assumptions.

In summary, the last year has been brutal for the company and its stockholders, but at its current valuation, the stock price just doesn’t make much sense, based on what we know today.

Full Disclosure: Long shares of Hewlett-Packard at the time of writing, but positions may change at any time

Amazon: The One Overvalued Stock I Wouldn’t Mind Owning

“I know you are a value investor, but if you were forced to own one growth stock with a hugely un-Peridot-like valuation, what would it be?”

I recently was posed this question and I have to say, even though it does go against my overall philosophy when it comes to investing, it is an interesting inquiry to ponder. I would actually say Amazon (AMZN) is the one overvalued stock I would not mind owning. Now, long time readers of this blog will recall I have long warned against Amazon shares. The valuation has always baffled me and raised red flags, but for years such caution was wrong, as the stock has done extraordinarily well. So why today, at $213 per share, 50 times trailing EBITDA, and 86 times 2011 earnings would I pick Amazon as an overvalued stock that might make sense owning? Well, it doesn’t hurt that they have defied my expectations for years, and I don’t think I am the only one.

I never really thought Amazon was going to be anything more than a great online retailer of other people’s goods. And while their position in that space will only strengthen as more and more people become comfortable buying online and allocate a higher percentage of their purchases from storefronts to the web, offering low prices keeps their margins minuscule. In fact, Amazon’s operating margins in 2010 were 4.1% compared with 6.1% for Wal-Mart and 7.8% for Target. It turns out that Amazon’s retail model is not more profitable than bricks and mortar stores, probably because they still need to maintain huge warehouses across the country (fewer bricks, yes, but bricks nonetheless), which is costly, and they have to offer rock bottom prices and free shipping to entice people to buy more online. Amazon has certainly perfected this strategy, but high margin it isn’t.

The part of the story I missed, frankly, was how strong they could be in new markets that they essentially help build from scratch. The Kindle e-reader was Amazon’s first real big venture outside of just trying to beat bricks and mortar stores at their own game. They successfully created a new market and more importantly, one that has the potential to be higher margin than traditional book printing (digital books). Sure, today they don’t make much money on each e-book sold, or the Kindle device itself for that matter (publishers are still setting prices for the most part and keep most of the revenue) but Amazon has the potential to eliminate the middleman in the years ahead. They could become the publisher and help millions of regular authors publish electronically. This is not unlike what Netflix is trying to do by funding their own original tv series now that they have millions of subscribers.

Next up for Amazon is an entrance into the tablet market sometime in the fall. With such a huge library of streaming music, movies, and television shows, there is nothing stopping Amazon from being a heavyweight in digital music and streaming video. Frankly, Amazon can offer a lot more to consumers with a web-enabled Kindle or Amazon-branded tablet versus the Barnes and Noble Nook or yet another me-too Android tablet like the Motorola Xoom or Samsung Galaxy Tab.

Other than Apple, Amazon appears to be the only consumer electronics player that could offer its customers differentiated products. The margins on commoditized Android tablets will head towards zero as everyone cuts prices to the bone to try and grab market share. Amazon seems well positioned to offer more with their products. As a result, they could easily be a formidable competitor to Apple in the tablet and e-reader markets. I’m not saying they pass Apple, but they certainly can pass Samsung, Motorola, HP, and whomever else to be the clear number two player, and I feel good about that prediction even before they have launched many of the products they have in the pipeline.

So what about the stock? Why could it go higher even at its current valuation? Look, at its current market value of $96 billion, I can’t possibly make a valuation case for Amazon stock based on cash flow and earnings in the near-term. However, if you simply look at their addressable market opportunity over the next 5-10 years and compare their market value with other leading technology and retail companies, you begin to see how a bullish argument could be made longer term. Apple is worth $330B. Google $170B. Wal-Mart $185B. Facebook could fetch $100B after its IPO. If Amazon continues to innovate like they have what would stop them from being worth $125B, $150B, or even $200B in five years?

I know I have completely changed my negative tune on Amazon as a stock investment (and don’t get me wrong, as a value investor I am not going to go out and buy it), but since I was asked the question, if I had to own one seemingly grossly overvalued stock, that would be the one I would pick. Given what they have done in the last five years, coupled with what they are planning and compared with the values of other companies they compete with, $96B seems a lot more reasonable if you ignore the fact that such a figure is 50 times trailing cash flow, or 86 times this year’s profits.

Thoughts?

 

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

Pandora IPO Reminds Us What 1999 Felt Like

We have a long way to go before another bubble in Internet stocks emerges but the recent IPO of LinkedIn (LNKD) and today’s debut of Pandora (P) serve as reminders of what the late 1990’s brought us. Back when Yahoo! (YHOO) was worth more than Disney (DIS) and AOL (AOL) was worth more than (and bought) Time Warner (TWX) there were plenty of bullish pundits arguing why the dot-com versions were indeed worth more because they had far more growth opportunities. While plenty of Internet companies proved to be worth those sky-high valuations, many more did not, including the aforementioned duo.

This morning Internet radio sensation Pandora has seen its stock jump nearly 50% from an IPO price of $16 per share. As a result, Wall Street is valuing the company at a stunning $3.75 billion despite revenue estimates for 2011 of only about $250 million (and more importantly, no profits). How does that compare with some non-dot-com radio competitors? Both Cumulus Media (CMLS) and Sirius XM Radio (SIRI) are valued at about 3 times revenues (including net debt). Cumulus, the more traditional radio play, has about the same annual revenue as Pandora (but has positive cash flow) and carries an enterprise value of around $700 million, approximately 80% less than Pandora.

Sirius XM may be the more relevant comp given that just a few short years ago they were considered the new age upstart in the radio business (and they adopted the subscriber model that many believe holds the key to Pandora’s future success). Sirius XM does have a public market enterprise value of $10.4 billion, three times that of Pandora, but with that comes annual revenue of $3 billion (12 times more than Pandora) and over $800 million in annual operating cash flow. Put another way, Sirius’s operating profits trumps Pandora’ operating revenue by a factor of three.

As was the case back in the late 1990’s, some of these new Internet companies will grow into their valuations and not leave early public market buyers hanging out to dry. That said, nearly $4 billion for Pandora seems more excessive than even LinkedIn, which is currently valued at $7 billion. I would not buy either one at current prices, but given their addressable markets, business models, and competitive landscapes, LinkedIn seems to have more relative promise at current valuations. Time will tell.

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

Actually, Ballmer and Chambers Haven’t Been Running Microsoft and Cisco Into the Ground

With Microsoft’s just announced $8.5 billion acquisition of Skype and recent troubles at long time tech darling Cisco, their respective CEOs are taking a lot of heat in the financial media lately. The assaults usually start by comparing stock price returns over the last decade or so, mainly because such data makes it easy to point the finger at the top brass. It is true that Microsoft stock is trading at the same price as it did way back in 1998 (don’t forget this excludes dividends, many reporters do) but that fact alone is not reason to conclude that the CEO has failed their shareholders.

The fact of the matter is that CEOs have control over certain things and no control over others. Their stock price’s starting valuation at a certain point in time is something they have no control over. Most of these 10-year stock price comparisons work to proof a point because the ten-year period just happens to begin near the peak of the internet and tech bubble of the late 1990’s, a time when most tech stocks fetched 50 or 100 times earnings. Not surprisingly, if you bought tech stocks at those valuations, you have a horrible investment on your hands, but that is true regardless of who was CEO.

So how can we fairly determine how well a CEO has done creating shareholder value? Earnings per share, plain and simple. Many CEO’s fail because they look at overall sales to determine how well they have done, but you can grow the size of your company without making shareholders a dime, so that is an irrelevent statistic for investors. Stock prices are based on two things; valuation multiples and earnings per share. Simply put, the market determines the former and the CEO plays a huge role in the latter.

So, how have Ballmer and Chambers done in the context of earnings per share growth over the last decade? Contrary to media reports, not that bad. I assembled the chart below which shows how fast earnings per share have grown at seven different large technology companies for the ten-year period from fiscal 2000 through fiscal 2010. The results may surprise you.

As you can see, Microsoft and Cisco have not been run into the ground by Ballmer and Chambers over the last decade. In fact, given that the long term average corporate earnings growth rate has been 6% annually, most of these tech companies have performed quite well.

Not surprisingly, Apple leads the way in terms of average annual earnings per share growth and Oracle, despite Larry Ellison’s huge pay packages over the years, has done very well too. Former internet stock analyst Henry Blodget over at Business Insider wrote this morning that John Chambers has failed as CEO at Cisco, largely basing his view on the stock’s performance, but the numbers don’t really support that. Again, a CEO really can’t influence P/E ratios that much. Opinions about a company’s future prospects are largely based on recent history, so if a CEO has done well in the past, the odds are good that their stock’s P/E will be above average, which ironically will hurt stock performance in the future.

While Microsoft is not near the top of the list above, Ballmer has kept pace with other rivals such as HP and IBM, so calling him a complete failure seems unfair. One could certainly argue that he could have done a lot better given the hand he was dealt, but the numbers still show he is about average in the tech world and above-average compared with all of corporate America.

The real surprise from this analysis is the clear loser of the group, Intel. The chip sector is definitely cyclical, more so than the hardware, software, and services industries which dominate this list, but Intel has unquestionably been the dud in the group, growing earnings at about half the historical rate of 6% for all U.S.corporations. If any management team should be criticized in large cap tech land, it should be the folks who have been running Intel.

All in all, a very interesting exercise.

Skype Deal Doesn’t Help Microsoft Jump Up on a Large Cap Tech Buy List

Large cap technology stocks are cheap, really cheap. Some of them haven’t traded at current valuations ever in their history as publicly traded companies (Cisco, for example). Microsoft (MSFT) is often included on such a list, and for good reason (the stock is dirt cheap), but the company rarely gives investors confidence that their strategy is right in the ever-changing tech world. Very smart investors like David Einhorn have added Mister Softee to their portfolios but the stock continues to be dead money in the mid to high 20’s. Today’s announced deal to buy Internet calling giant Skype for $8.5 billion does little to change the landscape for the stock.

Microsoft’s biggest problem is that it really doesn’t innovate very much anymore. Using the massive cash generation from Windows and Office, the company has merely copied their competitors in other areas. Their online services division continues to bleed red ink as Bing, Live, and other initiatives are simply me-too product offerings. The Zune music player was a complete bust and there is little reason to think the Windows Phone operating system will get any traction. The X-Box gaming system has been the company’s lone success outside of its core products, but with only a couple of competitors, that was an easier market to make progress in. And with the consoles facing new competition, that market is only going to get more difficult.

If anything, this Skype acquisition is interesting in that it signals a potential shift in strategy. Rather than continuously trying to build a Skype-like product that stands little chance of gaining traction against Skype and Google Voice, Microsoft has decided to just buy one of the giants in the space. Although the price tag seems excessive at $8.5 billion (and very few would argue that point), they likely had to overpay to wrestle it away from other bidders. In my opinion, it makes more sense for Steve Ballmer to overpay for Skype than plow hundreds of millions of dollars into a Microsoft clone that will be dead on arrival. In fact, Microsoft investors should hope that the company stops sinking billions into its unprofitable internet services division and uses that cash to buy other well established companies. There will still be a risk that Microsoft will tinker with Skype and any other future acquisitions, which would increase the odds that they lose their leadership position, but there is far more money to be made with Skype than with Bing, as one example.

As for the stock, this Skype deal does little to change my view that Microsoft is near the bottom of the list in terms of attractive large cap technology companies. I don’t dispute the stock is very cheap, but capital allocation has not been a strong suit of the company in recent years (and that is putting it mildly), and as a result, investors should have little confidence that Microsoft is on a path to building up more large, profitable business units. And with the continued assault from Google and others on their Windows and Office monopolies, that is what Microsoft must do if they want to see their stock price get out of the doldrums.

Reader Mailbag: Is Salesforce.com (CRM) a Good Short Candidate?

Tim writes:

“Hi Chad, you’ve probably looked at CRM as a “short,” any chance we’ll see a blog update with your thoughts on this one?”

Thanks for the question, Tim. I have several thoughts that pertain to Salesforce.com and other high-flying, excessively priced growth stocks in general.

Shorting these kinds of stocks is very dangerous. As a value investor, I certainly believe that excessive valuation is a huge red flag for any stock, but the key question is whether or not that sole factor alone is enough reason to bet on the price declining meaningfully, as opposed to simply avoiding it completely on either side. Unless there is a clearly identifiable deterioration in the company’s fundamentals, I tend to avoid shorting stocks merely because they are extremely overvalued.

The problem is that the market tends to give high growth companies elevated valuations as long as they keep delivering results. As a result, the short trade can go against you for a while, making it such that you must time the trade very well, and market timing is tricky. It is quite possible you will lose money for a while, and even if you are eventually right about a price decline, most of your gains by that point might only really recoup the losses you sustained initially. Without a negative catalyst (a breakdown in the operating business) it is very hard to time valuation-based short trades well enough to make good money consistently.

Now, in the case of Salesforce.com (CRM), the stock trades at about 90 times 2011 earnings estimates. Even for a company that is well positioned to grow for many years to come, one could easily argue that even at an elevated price of 40 or 50 times earnings, there is plenty of room for downside here. And I would not disagree with that. It really is just a matter of whether you want to explicitly bet on a huge decline, because you not only need to be right about the price, but you need such a decline to begin relatively soon after you short the stock, because momentum names like CRM can keep rising for longer than most people think.

Unless the market in general has another huge meltdown, these situations typically result in the stocks moving sideways for a long time, in order to grow into the hefty valuation Wall Street has assigned to them, assuming that their business fundamentals are not deteriorating. While I do not follow CRM as closely as many others do, I am unaware of any reason to think their business is set to take a dive. If that thesis is correct and the company continues to grow nicely, I would feel more confident betting on the stock moving sideways even as rapid growth in their software business continues.

To illustrate this idea, let’s consider past examples of stocks that were excessively priced, but still burned the shorts since the business fundamentals remained strong. Amazon.com (AMZN) is a prime example of a stock that many people have tried (unsuccessfully in most cases) to short in recent years. Amazon has continued to post phenomenal growth as it takes market share in most every category it expands into. In fact, just over the last few years many investors have argued it was a prime short candidate (and still do, at the current price of 52 times 2011 earnings estimates). As their business has continued to grow, Amazon shares have actually risen from around $70 two years ago to $165 per share today. Shorts over this period have gotten crushed.

If we go back in time, however, we can see that Amazon shares really have underperformed (relative to their underlying business fundamentals, anyway) for a long period of time. The stock peaked in December 1999 at $113 per share, when Amazon’s annual revenue was a mere $1.6 billion. Today, more than 11 years later, Amazon’s sales are on track for $45 billion annually, but the stock is only about 50% above 1999 levels. This is entirely due to the fact that the valuation in 1999 was so high that it already factored in years and years of stellar growth. Sales at Amazon have grown 28-fold (2,700%) since 1999, but the stock is up only 50% during that time. Believe it or not, that makes the investment a disappointment for those who had the foresight to predict Amazon’s explosive growth potential a decade ago. The valuation simply mattered more because it was already factoring in tremendous growth opportunities. Perhaps the same situation may be brewing with Salesforce.com.

As a result, I would personally prefer to avoid CRM rather than short it today. In more cases than not, shorting a stock based on valuation alone can get dicey pretty quickly, whereas finding a company with deteriorating fundamentals AND a high valuation has a much better risk-reward profile. Think Crocs, circa 2008, as one example.

Coinstar Shares Look Very Cheap After Guiding Down Earnings Expectations

Consumers should know Coinstar (CSTR)very well as the maker of coin counting machines found at grocery stores and more recently the owner of the Redbox DVD rental kiosks found in even more retail locations such as McDonald’s and Wal-Mart. I believe the stock, which has gotten hammered lately after an earnings miss for the fourth quarter, represents tremendous value. CSTR gives investors a rare combination of value and growth potential.

At around $39 per share (down from $67 late last year), Coinstar stock fetches only 6 times trailing cash flow. To put that in perspective, Microsoft sells for 7 times, Cisco for 8 times, and IBM for 9 times. Investors are clearly getting a valuation that is otherwise reserved for larger, slower growth businesses. This despite the fact that the company just reported that 2010 revenue soared 39% on the heels of a 50% jump in DVD rental sales (the more mature coin counting business grew by 7%). Despite giving more conservative guidance going forward after the company missed Wall Street’s fourth quarter expectations, Coinstar expects 2011 revenue to jump by about 24% with cash flow rising by 18%, as it continues to invest in growing the business. If management can deliver on these numbers this year (and after an earnings miss we should think they might give out forecasts they feel quite confident in reaching), the stock trades at only 5 times current year cash flow, unheard-of for a company growing like Coinstar.

Now, as with any investment, expectations and forecasts of future growth and valuation are not the only things to consider. Analysts would be quick to argue (and I would not disagree) that movie rentals are moving from disc-based to cloud-based, with the emergence of Netflix and other streaming platforms. Any market share gains that Coinstar’s Redbox kiosks might see with the pending bankruptcy of Blockbuster could very well be negated by more and more people signing up for Netflix streaming.

However, I still believe that the market for Redbox kiosks is bright, for two main reasons. First, with nearly 25,000 kiosks installed in grocery stores and retail outlets across the country, the convenience and cost ($1 a day) of Redbox rentals will make them attractive to both cost conscience movie watchers (if you only watch a couple movies per month you will likely opt for Redbox over an $8/month Netflix streaming plan) and those who enjoy the convenience of grabbing a movie on their way out of McDonald’s, Wal-Mart, or their local grocery store (just picture how easy children can convince mom and dad to get a movie for $1 before they leave the store).

The second reason I think it will be years before physical disc rentals will become completely obsolete is that there are still millions of Americans who are afraid of technology to a large degree (either due to things such as identity theft, or simply out of not being comfortable with operating high tech toys such as wi-fi enabled DVD players). To illustrate this point, let me share an encounter I had with a woman a couple of weekends ago.

After noticing that several Blockbuster locations were being liquidated near where we live, my fiancee and I decided to stop by and see if we could land any ridiculous deals (they were literally selling the store’s shelves as well as the DVDs sitting on them). Everything was for sale, and if you had a spare $350 sitting in your bank account you could buy the giant gum ball machine from your local Blockbuster store (we saw one being carried out by a man as we entered the store).

As I was perusing the aisles I helped explain the pricing structure to a woman in her 50’s or 60’s who was confused. We got to talking and she was mostly rambling about how disappointed she was that this store was closing because all of the other DVD rental places had also closed and now there was nowhere for her to go. I mentioned Netflix and she immediately dismissed it as a viable option “because you need a credit card for the box.” She was clearly confusing Netflix with Redbox, but the fact that she refused to use a credit card to rent a movie told me that Netflix would not be any better in her mind.

I bring this up because I think people like this woman are exactly the ones who will shun new technology like Netflix streaming. Eventually she will have to cave and start using Redbox for movie rentals most likely, and think about how many people like her there are out there. Not only that, but even if she felt comfortable using the Internet to order movies by mail (I don’t see her using Netflix mail order anytime soon, given that her explanation for why that wouldn’t work for her was that her printer has been broken for months and she can’t figure out how to fix it), I really don’t think she would proactively adopt such a technology when there are other “lower-tech” ways of getting a DVD such as Redbox (granted, a credit card will still likely be required).

In short, I think there will be room for both technologies for several years to come. While I subscribe to Netflix and have never actually used a Redbox kiosk, there are plenty of middle aged and older Americans who will. Not only that, but the Redbox kiosk in the grocery store I visit is often crowded with college kids as there are several universities in the area. Cost is probably the main factor there, as young kids can certainly operate Netflix streaming movies, but more likely lack the discretionary income to afford an expensive box with wi-fi and a monthly plan. So, there is definitely a market for Redbox with younger people too.

With Blockbuster in liquidation, Redbox should continue to grow, although Coinstar’s current stock price seems to not fully be factoring in such strong demand for their kiosks. I do not see any reason CSTR shares should not fetch 7-8 times cash flow, which makes a stock price of $60 quite a reasonable expectation.

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