Netflix Earnings: CEO Hastings Needs a New Crystal Ball

When Netflix (NAS: NFLX) reported third-quarter results last night, all eyes were on one metric: Subscriber growth.

Management said we'd see about 1.4 million fresh domestic streaming subscribers this quarter, give or take 400,000. Analysts came up with a consensus estimate of 1.43 million, just above the guidance midpoint. The numbers are in, and at 1.16 million new U.S. streamers, it's within the original guidance range, but at the lower end.

This makes it nigh-on impossible to deliver 7 million new accounts in 2012, as CEO Reed Hastings predicted at the start of the year. Updated guidance for the year-end quarter points to 5.7 million additions -- at best. And down the stock goes, plunging as much as 23.7% in after-hours trading.

It really doesn't matter that Netflix crushed earnings with $0.13 of income per share, far ahead of the $0.04 analyst consensus. This company isn't about current income, but a play of long-term growth. That's why investors panic when Netflix fails to hit its growth targets.

Forecasting is hard. Let's go shopping!
Now, it's not like Hastings has a perfect crystal ball when it comes to estimating subscriber growth. Let's have a look at predictions and real results in the streaming era:

Source: Quarterly reports from Netflix.

The results tend to fall within or above guidance -- except when Hastings torpedoed himself with the forcible separation of DVD and streaming plans, swiftly followed by the Qwikster disaster. The company could still hit 7 million domestic additions in 2012, but only by beating the top end of its own fourth-quarter growth targets by 67%. That's asking a lot, even if it actually happened in last year's holiday quarter.

When asked to explain the shortfall, Hastings fell back on how hard it is to estimate customer growth.

Admittedly, he set that 7 million target too high. It was based on the 2010 fiscal year to take the whole Qwikster thing out of the equation, but 2010 just happened to be a really fantastic year:

Source: Netflix letter to shareholders, Q4 2010.

Not even Netflix expected that kind of success back then: "At the start of 2010, our best estimate for net additions for the year was about 3.6 million, which shows how hard annual forecasting is when the opportunity is expanding so rapidly," Hastings said at the time.

The London Olympics turned out to reduce subscriber additions this quarter, just as Hastings had expected. Furthermore, Netflix is running into more so-called involuntary churn these days -- customers who might like to continue their service but their credit card charges don't get approved. That's because Netflix is becoming more "mainstream" while broadband Internet connections become more ubiquitous, which adds up to exposing the company to lower-quality customers.

This is not a new concept in the entertainment industry. Satellite broadcaster DIRECTV (NAS: DTV) has long protected its margins by marketing itself as a premium brand, while rival DISH Network (NAS: DISH) went with lower prices and ran into the same involuntary churn problem. This is clearly visible in the two companies' gross margins:

DTV Gross Profit Margin Quarterly data by YCharts.

...and yet the stocks have largely been joined at the hip through it all:

DTV data by YCharts.

I bring the satellite guys up because they illustrate that you can deliver shareholder value with a low-cost content delivery plan, even if it means attracting a less consistent class of customers. DISH has done it, and Netflix is doing it, too.

What's next?
So Netflix shares aren't setting 52-week lows on this report (well, not in the early morning, anyhow), but it's awfully close. The story has changed a bit as management admitted to setting its targets a bit high, but the long-term thesis is intact. Hastings still sees an American market that's two or three times the size of Time Warner's (NYS: TWX) HBO service, given his own product's lower price point and the inherent advantages of online distribution. At 25 million domestic streamers today, Netflix has only grabbed about 33% of that market and has plenty of hometown growth left to explore. And we haven't even discussed international markets yet, which dwarf the U.S. sandbox in the long term.

I'm not selling my Netflix shares here, though I may need to kill my bull call options spread. My current options break even at about $100 per share and expire in January 2013 -- just days before the next earnings report is likely to land. Since Netflix shares live and die with updated subscriber counts, the stock isn't likely to double before it stops making a difference to my portfolio.

The outsized returns will come -- just not quite as qwikly as Hastings or I may have thought.

The precipitous drop in Netflix shares since the summer of 2011 has caused many shareholders to lose hope. While the company's first-mover status is often viewed as a competitive advantage, the opportunities in streaming media have brought some new deep-pocketed rivals looking for their piece of a growing pie. Can Netflix fend off this burgeoning competition, and will its international growth aspirations really pay off? These kinds of issues are a must-know for investors, which is why we've released a brand-new premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to both buy and sell the stock. We're also offering a full year of updates as key news hits, so make sure to click here and claim a copy today.

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Fool contributor Anders Bylund owns shares of Netflix, and has created a bull call spread on top of his shares. Check out Anders' bio and holdings, or follow him on Twitter and Google+. The Motley Fool owns shares of Netflix. Motley Fool newsletter services recommend Netflix and Time Warner. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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