Is Netflix a Short Term Sell or a Long Term Buy?

It has been the case time and again in recent memory: Wall Street is less about “what you’ve done for me lately” than about “what you plan to do for me next.” That was a lesson served anew Monday to Netflix (NFLX) which reported decent earnings after the close of markets but disappointed with their forward projections.

After building positive momentum in recent quarters, the movie rental service reported Q1 earnings of $13.4 million or (21 cents a share) on revenue of $326.2million. Less stock compensation related charges, the winter quarter would have yielded 23 cents a share. Those results were a reasonable increase over earnings of $9.9 million (14c/share) on revenue of $305.3 million for the same period a year ago.

The company’s net income for the quarter matched most analyst consensus expectations. On total revenue, analysts were expecting a slightly better result: somewhere between $326.4 to 326.9 million depending on which polling service is referenced.

Total subscribers were also much improved over the year ago period. For Q1 the total was up to 8.24million from 6.8m last year. Churn, the measure of subscriber cancellations, was also improved. The quarter’s churn result was just 3.9%, down from 4.4% a year ago, and also improved sequentially over the fourth quarter which had a churn rate of 4.1%. In the analysts' call, Reed Hastings characterized that as the best in the company’s six years as a public company.

Another positive was subscriber acquisition costs [SAC], the hefty advertising and marketing related expenses Netflix pays to gain new subscribers. For Q1 the result was down to $29.40, a significant decrease from the $47.46 paid last year and even the $34.60 paid for Q4. As with churn, it was the best result in 6 years of being public.

Part of the SAC decrease can be attributed to adjustments in the ad market related to the economy. (Financial services firms that typically pay heavily for Internet advertising have decreased their marketing expenses. That, in turn, has cut demand and lowered prices for ad inventory Netflix might have otherwise paid a premium for.) The drop off in acquisition costs also probably owes to strategy changes at Blockbuster (BBI) that have led to less near-term competition.

Where things soured for Netflix was guidance. Despite raising full year forecasts for total subscribers and revenue (subscriptions are now forecast to be 9.1 to 9.7 million, up from a prior range of 8.9 to 9.5.; revenue is now forecast at $1.35billion to $1.39billion, up from a range of $1.345 billion to 1.385b), the company lowered projections for per share earnings to a range of $1.16 to $1.29 (emphasis on the midpoint of $1.23). Analysts had been expecting about $1.25 a share.

That adjustment along with drops in gross margins (31.7% versus 33.8% in Q4) and slowing growth in the current quarter trimmed more than ten percent off the stock in afterhours trading.

The market’s reaction may prove excessive over a longer time horizon. Part of the earnings shortfall is likely due to future investment that could bring positive results. More specifically, Netflix has been in the process of building a next generation delivery system (Internet streaming instead of DVDs) for more than a year. Today, that streaming service (called "Watch Now") makes more than 9,000 titles available for instant viewing. Content licenses for these titles come at an increased cost (how much so hasn’t been disclosed).

The prospect of this streaming service displacing the core DVD business is a long way off, but the company’s goal is “to be a great Internet movie service by combining DVD by mail with Internet streaming and to grow subscribers and EPS every year.” The aim is to prepare for the future and anticipate an eventual decline in DVD interests. Increasing online content spending is a step in that path, even if sacrificing some Earnings Per Share upside.

CEO Reed Hastings pointed out in the analyst call that more content spending makes the service “become more attractive to consumers, which in turn makes us more attractive to Consumer Electronics partners.” That, in turn, helps secure partners to embed Netflix client software into devices like Blu Ray players and game consoles. These partnerships make Netflix more significant.

Last quarter, LG (LPL) was revealed as the first partner in the embedded hardware program. Now, says Hastings, “I can tell you we have LG plus three additional partners actively working on integrating our technology into their products. Three of the four partners are major companies which each sell millions of devices per year and will enable the Netflix functionality in some of those devices likely in Q4 of this year."

The result of these efforts may not positively effect the bottom line for several years but for long term investors it could prove significant.

The soundbyte to close on that point came from Netflix CFO Brian McCarthy. He answered an analyst’s question saying, “absent a competitive threat to the economic wellbeing of the business, which we don’t see, we have the resources to make one large strategic investment and we’ve chosen to make that investment in growing our ability to deliver content over the Internet to TV sets and other devices, in lieu of reinvest doubling down in the physical world.”

Comments

[CrossProfit]

“absent a competitive threat to the economic wellbeing of the business, which we don’t see, we have the resources to make one large strategic investment and we’ve chosen to make that investment in growing our ability to deliver content over the Internet to TV sets and other devices, in lieu of reinvest doubling down in the physical world.”

see both;
crossprofit.com/search......
crossprofit.com/view_s...

Slowing growth is what management is talking about which in return should eventually reduce the P/E multiple. In order to maintain a 35/40 multiple, there can NOT be any signs of weakness as we are seeing now.

The 50+% boost from BBI's demise was overdone.

Toudo.com and YOUKU (free Chinese sites) are still free and when they start charging customers (and pay royalties) they will not only be legitimate competition but will cost less than NFLX. Their cost structure is lower and are willing to work on smaller margins.

AMZN and AAPL don't have the traffic that these two have outside the U.S.... also, both are upgrading their servers for faster on-line streaming (no need to download or mail DVD's etc.).

It is beginning to look like a five-way-horse-race, assuming BBI gives up altogether. If NFLX doesn't see a competitive threat on the horizon, then they should get their eyesight checked!

These type of comments sort of remind us of BA's comments about Airbus when they first got started...and that didn't take as long as the rocket scientists were predicting at the time!

CrossProfit

[DSX Lover]

Netflix is a Long-term DOG from now on.

[Lisa]

Good article.

The SAC is an interesting data point on the Internet ad market. Specifically, the article said:

"Part of the SAC decrease can be attributed to adjustments in the ad market related to the economy. (Financial services firms that typically pay heavily for Internet advertising have decreased their marketing expenses. That, in turn, has cut demand and lowered prices for ad inventory Netflix might have otherwise paid a premium for.) The drop off in acquisition costs also probably owes to strategy changes at Blockbuster (BBI) that have led to less near-term competition."

Has anyone seen other data points suggesting falling CPMs in the online ad market? Given Google's better-than-expected results, more evidence is needed to substantiate this claim.

[Patchie]

The stock is opening down $5.50/share or 14% on speculation after meeting Q1 estimates. Apparently hitting targets is no longer acceptable. With such a large short position in the stock I can only wonder who is initiating all the negativity we see before us. Let the raiding begin.

[Chandler Lutz]

Nice Article! I think you make a lot of good points, but I just don't see what Netflix's competitive advantage is. To me, the barriers of entry seem quite low and the valuation is too high. For these reasons I don't even consider Netflix a possible investment.

One more interesting note is that I believe that Reed Hastings, The Netflix CEO, is on Microsoft's board of directors. Hence, Microsoft might be one of the mystery partners referred to in the article above. Netflix needs a big muscle partner like Microsoft in order gain competitive strength.

Netflix's story will be an interesting one to watch, but too tough to call....we'll have to wait and see what happens

[Rob L]

SELL...this company is way overvalued, 30 PE for a company that sells DVDs? Ha Ha a joke.

[Cousin A.]

The stock may or may not be over-valued. I don't know, but as a long-time subscriber, but not an owner of Netflix, I can attest to one "competitive advantage" of the company. Their outstanding customer care and service has been referred to by Consumer Reports mag and by others. Both the customer service and the easy access to it by email or phone is a plus, and is truly a competitive advantage. Their unusually excellent care of their subscribers started out good, and it has continued to improve over the years. That kind of customer care does have, and will continue to have value.

[LouieJunior]

Look what they are paying for each new sub! Ugly trainwreck coming in a few quarters.

[Seth]

Lisa,
thanks for the comment. Regarding the ad markets, its about segmentation. Google is definitely one barometer but their income draws far less from display advertising then competitors so its an incomplete picture. It's the softness in the display sector at issue here. (That softness has been forecast for a while and can also be seen a little in Yahoo's projections, WPP's, Microsoft's and others).

To throw some numbers at it: Netflix spent more than $69m on display advertising between January and June 2007. Its a big part of SAC costs.

If you look at the mix of top 10 display advertisers back in November, 7 of the top 10 were financial services firms. If you look at the data for Feb '08, it's down to 4 (5 if you include an Auto insurer). Netflix, at the same time, is in the top 10 at number 7.

....Per earnings, their SAC costs were down to the lowest level since going public yet their stake in Display ads was up. That seems to support the argument in my article.