3 Takeaways You Might Have Missed When Netflix Reported Earnings

When Netflix reported earnings on Monday night, investors expected big things. Share prices had soared 193% year to date when the report dropped in, but fell 5% on the news. Investors and analysts focused on 0.6 million new domestic subscribers during the quarter, worrying that it was too low a number.

That's the only number you've seen in most Netflix headlines this week, but there's much more to the story. Let's take a look at three important takeaways you may have missed.

Guidance? We don't need no stinkin' guidance!
Some analysts were hankering for more than 1 million new subscribers from the long-awaited extension of Arrested Development alone. Against that backdrop, 630,000 new American subscribers looks like a big miss. You can read it as Netflix losing subscribers this quarter if you back out the banana stand!

But then you're ignoring the company's own guidance for the quarter. Netflix set the guidance range for the second quarter between 230,000 and 880,000 net additions. 630,000 falls in the upper half of that range, which was set with Arrested's debut in mind.

Moreover, you might recall last year's second-quarter report. That time, Netflix shares plunged 25% overnight as seasonal effects held back subscriber additions over the summer. May I remind you how share prices nearly tripled over the next six months, when the fun and profitable half of the yearly growth cycle played out? The same seasonal effects are still in place, holding Netflix back in the summer with a commensurate boost around the holidays.

So the performance didn't blow guidance out of the water, but certainly shouldn't count as a big miss, either. And as a Netflix shareholder, I'm certainly looking forward to the third and fourth quarters this year.

The HBO limit doesn't apply to Netflix
Skeptics often scoff at Netflix's goal to become two or three times the size of Time Warner's premium cable channel HBO. That channel has been bumping against a glass ceiling for years, never breaking through the 30 million subscriber threshold. If a well-established consumer brand with the money and marketing might of Warner behind it can't move beyond this limit, why should we accept 60 million or 90 million as a destination for Netflix?

Well, Netflix is about to cross that illusory threshold. The low end of third-quarter guidance points to 30.4 million American subscribers. Pop goes the glass ceiling, unless you expect management to set unreachable short-term targets.

Don't forget that you're looking at a virtuous cycle. Once Netflix collects enough revenue to cover its content costs, every additional streaming member is almost 100% pure profit. The streaming delivery costs are minuscule.

What does this mean for the long-term growth trend? Here's how CEO Reed Hastings put it on the earnings call:

What happens is by the time we get to 40 million and 50 million, we get the content better and the service better. And so it's not 60 million or 90 million for the current service. It's 60 million or 90 million for the future service that's much improved with maybe a lot more originals and just incredible streaming.

In other words, as Netflix makes more money from higher customer counts, the company will invest this cash in stronger content and better technology. And as long as you're building a better service, why wouldn't you expect subscribers to keep signing up?

Recommendations matter. A lot.
Here's one that caught me by surprise: More than 75% of the viewing hours on Netflix start with the recommendations system.

Room for improvement: My family has varied tastes. Image source: Author's screenshot of current recommendations.

That's a huge number, and it underscores the competitive advantage Netflix built over the last decade or so. In short, Netflix is pretty good at figuring out what you want to see. The company wants to become the ultimate cure for channel surfing, because that would mean gluing your eyeballs to the Netflix screen in a way that traditional TV channels just can't match. No, not even HBO.

It's an extension of what set TiVo apart in the early days. Your channel-surfing taught TiVo's digital recording boxes a lot about your viewing habits, which allowed the box to present a list of recommended content. That guidance is arguably more valuable than the simple ability to record TV shows without worrying about VHS tapes, and is the foundation of TiVo's strategy even today.

Netflix digs even deeper. The company knows what you're watching, just like TiVo, and both systems come with star-based ratings systems. Netflix also combines this information with patterns culled from DVD and streaming customers since the beginning of red mailers. Mass psychology and big data analysis come into play. Netflix doesn't just know what you might like to see right now, but can also predict the kind of content it should buy or produce for people like you in the future.

This is a massive moat. Amazon.com can't match it, because the company has nowhere near the wealth of customer data that Netflix sports. HBO sure can't run in this race until its online HBO Go service gets a decade of operating data under its belt. The same goes for Hulu, no matter which media giant ends up taking control of that service.

TiVo does have a similar data library and aims to exploit it in the next phase of its checkered history. That's the main reason that I still own that stock: There's a solid advantage in play, and TiVo-less cable operators will find it hard to match this high-quality feature.

But nobody else can compete with Netflix's data trove. Not even TiVo. The fact that 75% of viewing hours come from recommendations is evidence that it works. It's an investable advantage that most people ignore.

But now you know. I own Netflix shares, and the stock is one of my most successful CAPScalls to date. This report did nothing to damage my long-term thesis for owning Netflix shares.

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The article 3 Takeaways You Might Have Missed When Netflix Reported Earnings originally appeared on Fool.com.

Fool contributor Anders Bylund owns shares of TiVo and Netflix, but he holds no other position in any company mentioned. Check out Anders' bio and holdings or follow him on Twitter and Google+. The Motley Fool owns shares of Amazon.com and Netflix. Motley Fool newsletter services have recommended buying shares of Amazon.com and Netflix. Motley Fool newsletter services have recommended creating a bear put ladder position in Netflix. The Motley Fool has a disclosure policy. We Fools may not 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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