Netflix Investors Have Real Cause for Concern


What a difference a day and an earnings report make. At the time of writing, shares in video-delivery giant Netflix (NAS: NFLX) are 18.6% off their Monday closing price -- this, after the market had time to digest the company's first-quarter results. The company hit its earnings estimates but is clearly off track on subscriber growth -- a key metric for Netflix, and one investors have good reason to be concerned about.

First, the good news
Here are the first-quarter highlights:

  • Gross revenue grew 21% year over year.

  • The company added 1.7 million U.S. subscribers.

  • The company launched new streaming services in the U.K. and Ireland.

Netflix now has more than 26 million global-streaming customers, an impressive number that clearly backs up the company's own claim that it's the "world's leading Internet TV network." Netflix also hit its earnings estimates. This is usually the deciding factor in whether the stock pops or dives, but this quarter Wall Street and investors were focused on something else.

And now for something completely different

  • While gross revenue is up, gross profit is down, for a YOY change in gross margin from 39% to 28%.

  • Net income has gone from $60,233 million to -$4,584 million YOY.

  • Earnings per share have likewise plummeted, from $1.11 this quarter last year to -$0.08 this year.

Gross margin is an indicator or brand strength, pricing power, and production efficiencies. An 11% drop means something significant has changed in the top lines of the income statement, and unless the company can make up the difference farther down, that 11% comes directly off the bottom line. Whatever else contributed to the net-income nosedive, the change in gross margin certainly contributed.

Gross margin aside, this quarter the market and Wall Street focused on the rate at which the subscriber base is growing. Yes, Netflix added 1.7 million subscribers this quarter, a hefty number, but the company is projecting gross total subscriber additions of around 7 million for 2012. And for the second quarter of the year, which has just begun, the company is projecting that just an additional 600,000 subscribers will come on board.

Through the looking glass
I'm sure you see where the math is going here. If all goes as planned, Netflix will have 2.3 million new subscribers at the year's halfway point, so it will need to add 4.7 million subscribers in the last half of the year to make its goal. That's 2.35 million per quarter -- well above the current rate.

The company is basing this subscriber growth model on 2010, when the company also added 7 million new subscribers. On the investor conference call, CEO Reed Hastings said, "We feel very good about the year," but all he seems to be able to offer in defense of the slow start and projected weak second quarter is that this year there would be more "quarterly seasonality ... because the company was starting with a larger number of subscribers."

He finally added: "Our gross additions are consistent with historic patterns." His rationale is, frankly, weak, and that's not just your columnist's opinion. The market obviously didn't like what it saw, either.

Competitors at the gates
Competition for Netflix, as we all know, is growing and is only going to get more fierce. (NAS: AMZN) is aggressively adding more content to its Prime service, which gives members free two-day shipping on a wide range of its products as well as thousands of movies and TV shows available for instant streaming.

Apple (NAS: AAPL) has just taken the next step in the evolution of its still fledgling Apple TV, by upping the program resolution to as high as 1080p HD and giving it a faster processor. Google (NAS: GOOG) is also out there with its own Google TV, which is in an even more fledgling state than Apple TV. But both Google and Apple, with the gargantuan financial resources at their disposal, will be Internet TV powerhouses when they finally decide to go all in on it. Content is king in that world, and they will be able to load up on it.

And, of course, last year Netflix was its own worst enemy, with its botched attempt at rebranding its DVD-by-mail service and the abrupt 60% price increase. The brand took a big hit on both actions. Hastings came off as squirrely, arrogant, and out of touch on the rebranding effort in particular, and the company lost customers and credibility overall.

Foolish bottom line and a top stock pick
Of course, you can't really blame Hastings for going easy on the details regarding subscriber growth. It's all he really has to go with at the moment, and he needs to go with something. The company is running in the red, and Hastings is predicting Netflix's return to profitability this year. That can only happen with more subscribers -- a lot of them. The stock price took a big hit last year with the company's ill-conceived actions. This one is much more of a mild reaction, but investors should see it as a warning shot.

This is going to be an axial year for Netflix. If subscriber growth doesn't come through as promised, expect further investor revolt. While you're waiting to see what happens, pass the time by checking out the stock The Motley Fool is calling its top pick for 2012. Learn all about it in this special free report: "The Motley Fool's Top Stock for 2012." Get it while it's still available and the stock is still hot.

At the time thisarticle was published Fool contributor John Grgurich gave up television in protest years ago, after Magnum, P.I. went off the air. Neither he nor Higgins' two angry Dobermans own shares of any of the companies mentioned in this column. Follow John's dispatches from the front lines of capitalism onTwitter, @TMFGrgurich.The Motley Fool owns shares of, Apple, and Google.Motley Fool newsletter services have recommended buying shares of Google, Apple,, and Netflix and creating a bull call spread position in Apple. The Motley Fool has a gripping disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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