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3 Terrible Reasons to Sell Netflix

Shares of Netflix (NASDAQ: NFLX) got whacked after its latest earnings report. The stock fell as much as 14% in the aftermath of the second-quarter report as Netflix added 5.15 million new subscribers, short of its forecast at 6.2 million.

After the stock's blistering rise, investors may be wondering if it's time take profits, especially after the recent dip. However, one quarterly subscriber miss isn't a good reason to sell shares of the leading streamer. Let's take a look at three terrible reasons to sell the stock, starting with that one.

Image source: Netflix.

1. It had a bad quarter

As the saying goes, you can't make an omelette without breaking eggs, and you can't have a blockbuster stock like Netflix, which has returned more than 30,000% in its history, without a few quarterly setbacks. Netflix isn't perfect -- no company is -- and investors have to accept that it won't meet its own quarterly forecasts every single time. However, the stock has overcome every sell-off and miss it's faced thus far, and I see little reason this time would be different, especially as it's tacked on a record 26 million new subscribers over the last year, growing its base by 25% during that time, even as it's raised prices.

That's a testament to the company's pricing and brand power, and that momentum -- along with its content pipeline with programming from the Obamas, Oscar-winning directors like Martin Scorsese and Alfonso Cuaron, and showrunners like Shonda Rhimes and Ryan Murphy -- should deliver strong results through next year at least.

2. Competition is on the rise

It's true. Netflix is facing increasing levels of competition. AT&T envisions a bigger and broader HBO following its acquisition of Time Warner. Apple is angling for a position in streaming video, throwing $1 billion at original programming. Amazon is spending increasing amounts on the video entertainment vortex in order to entice more Prime members, and Disney (NYSE: DIS), perhaps the fiercest competitor of all, is preparing to launch its own streaming service, following the unveiling of ESPN Plus earlier this year. Disney is also in the process of acquiring Fox, pending regulatory approval, which would give it a bevy of programming and entertainment assets, as well as majority control of streaming service Hulu, a joint venture among several networks.

However, there are two reasons investors need not worry about this. First, Netflix has already faced such competition, and its growth has only accelerated. HBO, Showtime, Hulu, and Amazon have all been at the streaming dance for years, but that hasn't stopped Netflix from reaching 130 million subscribers. And more importantly, the market for global video entertainment is enormous. This is far from a zero-sum game, and all of these players know it. As connectivity and technology get even better, especially in the developing world, Internet TV will become the norm, as Netflix CEO Reed Hastings has predicted. That means consumers will likely subscribe to multiple services, as many Americans already do. Since each service has its own content, the providers act more like complements rather than substitutes.

3. It's burning billions in cash

Netflix expects negative cash flow of $3 billion to $4 billion this year. Normally, that's a big red flag in business, and Netflix has gotten plenty of flak for it in the financial press. However, investors have to look at the big picture, here, as such spending is part of the company's larger strategy, and also part of the natural cycle of programming costs as Netflix gets bigger. Negative cash flow has ballooned because the company is making an investment in its future.

Netflix is ramping up spending because it recognizes the effect that more and better content has on subscriber growth. It also knows the market is ripe for new subscribers as the broader industry is booming, and competition is on the rise. According to classical business theory, it's much easier to acquire new customers while an industry is growing than when it matures. That's why Netflix is spending so much on content -- to get the biggest possible piece of the pie.

I'd encourage all Netflix investors, especially those considering selling the stock, to read its Long-Term View. It's a unique document that spells out management's strategy and the beliefs underpinning it. For instance, it explains why management sees such a massive opportunity in streaming as well as how it determines how much to spend on content and marketing.

Though I wouldn't sell Netflix for the reasons above, there are some things that would make me question my ownership. A sudden change in management that saw CEO Reed Hastings leave the company would cast a cloud on the stock, as Hastings is the co-founder and has guided the company since its early days as a DVD mailer. A crisis that dramatically hurt the brand, such as the one Chipotle experienced after its E. coli outbreak, would also lead me to second-guess Netflix's future.

However, the business itself continues to look as solid as ever. Quarterly misses are part of the investing game, and Netflix has already made a number of moves since the report that show it's still getting better. Look for the streamer to shake off the latest report and get back to business as usual.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Jeremy Bowman owns shares of Netflix. The Motley Fool owns shares of and recommends Amazon, Apple, Netflix, and Walt Disney. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.

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