A winning trade is often about connecting the dots. If one company is set to steal market share from another, it often pays to take two actions: Go long the market share winner and short the market share loser.
 
Unfortunately, I failed to connect the dots in early August when I suggested investors go long on Coinstar (Nasdaq: CSTR), due to a risky pricing move by rival Netflix (Nasdaq: NFLX).

My long pick on Coinstar has worked out thus far — shares have risen 10% since early August in an otherwise difficult environment for stocks (the S&P 500 has gyrated wildly and risen only 2% since then). I should have set this as a paired trade, calling for an outright short on Netflix as well. The stock has plunged an eye-popping 45% in just six weeks, wiping out $6 billion in market value. I should have been more explicit in detailing just how Netflix’s pricing changes brought major risk to the stock.

 

That said, a 45% rout in such a short period is starting to look like a pretty severe overreaction. Netflix stumbled badly, but investors have seemingly lost sight of the fact that a huge amount of value remains in this business model. Rivals are nipping at the company’s heels, movie studios are exacting tougher terms, customers are currently apoplectic over the pricing changes, and the U.S. Postal Service is looking at raising postal rates. Still, this is a business model that has real staying power, single-handedly creating another major entertainment platform for millions of consumers. And when the dust settles on all of the recent drama, investors will likely re-embrace this stock as a moderately growing, highly-profitable business that is now valued too cheaply.

#-ad_banner-#Slowing growth
Netflix’s days as a fast-growth upstart are likely over. Sales grew 22% in 2009, 29% in 2010 and are on track to grow a heady 50% this year to around $3.3 billion. Consensus forecasts call for another 38% spike in 2012, although analysts may need to take that forecast down a notch or two (perhaps below 25%) to account for the recent disruptions caused by pricing changes. Still, sustained sales growth above 20% at a time when consumers aren’t spending much is a powerful statement.

Netflix has been able to grow so much because it offers such compelling value. The price of one movie ticket and a bucket of popcorn is on par with an entire month’s worth of Netflix’s movies. What is so important about the steady sales growth is its impact on the bottom line. Netflix generated $607 million in free cash flow last year, and on an enterprise value basis, shares trade for just 11 times that figure, equating to a free cash flow yield of 9%. This is a metric sported by many companies that are far more mature and have run out of major growth opportunities.

But Netflix still has several arrows left in its quiver. For starters, the company has just announced plans to move into the video game rental market — a move which figures to upend the industry just as Netflix revolutionized the movie rental business. The size of the potential market opportunity is still unclear, but any major traction is a clear catalyst for the stock. As a possible point of reference, privately-held GameFly, which has a games-by-mail platform, has about 400,000 subscribers paying $16 and $37 a month.

Second, Netflix will soon roll out its service in Canada, the Carribbean and Latin America. Taken together, those markets still don’t add up to the size of the U.S. market, but many firms such as DirecTV (NYSE: DTV) have found that Latin America in particular generates higher levels of entertainment spending than had initially been anticipated. Rumors of a European launch — perhaps in the U.K. or Spain — set for early 2012 have begun to build as well.

Risks to Consider: Perhaps the biggest threat to Netflix’s business model comes in the form of costs. Movie studios are now playing hardball, trying to exact higher prices on renewed contracts. The challenge for Netflix is to pay up, but not overpay. In some instances, it will need to step back and walk away from unreasonable demands from a particular movie studio or TV network. This reduces the amount of titles it can offer customers, though no other firm comes even close to Netflix in thist respect.

Shares may also not rebound until investors have a better sense of the impact of an impending split that will separate the DVD-by-mail service from the streaming video side. Each business has its own set of economics, and investors will want to gauge what each business is likely worth.
 
Netflix’s recent stumble is actually fairly typical when a high-growth company morphs into a more mature cash cow. The fact shares have fallen from a peak of $300 to $130 in less than three months shows just how wrenching this transition can be. At this lower price, the stock now offers a decent blend of value and growth. There’s no reason to assume growth will slow to less than 20% during the next few years, either — the U.S. customer base keeps rising and foreign markets are just now being cultivated. This should help show the dynamic free cash flow potential of this business, which could hit $800 million by 2013, by my math. Shares, at around eight times that figure, are simply too severely discounted in light of recent events.

Action to Take–> The catalyst here is Wall Street research. Look for an increasing number of analysts to step forward and upgrade their ratings on the stock once shares are no longer falling daily. (They’ve fallen at least $10 for four straight trading sessions at the time of this writing.) Once analysts chat-up this beaten-down name, look for shares to rebound from a recent $130 back toward the $200 mark. This stock may have never deserved to trade up to $300, but $200, which would represent 11 to 12 times projected 2013 free cash flow, appears about right. So if you’ve missed the boat on Netflix in the past, now may be the time to jump in.