Reed Hastings Opens the Red Envelope

Netflix (Nasdaq: NFLX  ) enjoyed another recession-thumping quarter. So how come its shares were trading lower last night? Here at the Fool, we checked in with CEO Reed Hastings to discuss the latest numbers and the DVD rental specialist's future.

First, the vital stats
Netflix posted a 21% spike in revenue to $394.1 million during the first quarter. Earnings per share grew even faster, soaring 76% to $0.37. Those silly folks on Wall Street had figured that the company would only be good for $0.31 a share on $390.9 million.

Netflix had 10.3 million subscribers by March's end, closing out the quarter with 920,000 more movie buffs than when it started, and 25% more than the 8.2 million members on its rolls a year ago. The company also raised its targets for 2009:

Metric

New Guidance

Previous Guidance

Ending subscribers

11.2 million - 11.8 million

10.6 million - 11.3 million

Revenue

$1.63 billion - $1.67 billion

$1.58 billion - $1.635 billion

Earnings per share

$1.56 to $1.72

$1.43 to $1.59

Where is the earth-shattering ka-boom?
Higher guidance. Widening profit margins. An all-time low subscriber acquisition cost of $25.79 per gross addition. This is typically the kind of rosy news that sends a stock off to the races.

Unfortunately, shares were initially trading lower in after-hours trading last night. A few things may have spooked nocturnal traders.

  • Netflix hit a new 52-week high last week, so "selling on the news" seems perfectly natural for jittery investors.
  • Momentum is slowing on the subscriber front. It took just six weeks during the quarter for Netflix to add 600,000 net new members, hitting the 10 million mark. The company landed only 300,000 during the final seven weeks of the quarter. The company claims that slowdown is a longtime seasonal thing, since the first quarter is always front-heavy with holiday gift redemptions.
  • The second quarter is also seasonally sleepy, and the company's guidance calls for adding just 100,000 to 300,000 additional accounts this quarter.
  • Churn clocked in at 4.2%, an increase from last year's 3.9% rate.

Reed all about it
I asked CEO Reed Hastings about the churn in an interview after the company's analyst conference call. All that turnover seemed problematic, especially since the company is investing in online streaming to make its service more indispensible and sticky. Is the economy to blame for customers' comings and goings?

"It could be the economy," Hastings said. "It could also be that we make it very easy for subscribers to put their accounts on hold if they go on vacation or don't have enough money for a month or two. When a subscriber goes on hold, we count that as a cancellation. What you can look at -- as a good stable indicator -- are net additions. And net additions continue to grow."

If that's the case, it's hard to argue against a company that just landed 920,000 net new subscribers during a bear of a quarter for the U.S. economy.

Going old-school
Fellow Fool Mac Greer went on to ask Hastings to rank the competition -- and threw in digital heavyweights such as Amazon.com (Nasdaq: AMZN  ) and Apple (Nasdaq: AAPL  ) along with real-world DVD lenders like Blockbuster (NYSE: BBI  ) and Coinstar's (Nasdaq: CSTR  ) Redbox. Tellingly, Hastings placed Redbox and Blockbuster at the top of the list.

Redbox and its $1 rentals appear to be a particular thorn in the company's side. Netflix likes to point out that it's mostly immune to its rival's influence; while Redbox stocks primarily new releases, just a third of Netflix's rentals are for fresh titles.

I had to question the validity of that metric. After all, a day after a new flick comes out, it may be showing as a "Long Wait" at the top of my Netflix queue, so I'll be sent an older catalog title instead. Surely the lack of availability for new titles creates the illusion that so many Netflix subscribers are aficionados of the classics. Right?

"It's hard to know if we had unconstrained new release inventory what it would be," Hastings responded. "It would be a little higher, but not dramatically. With 100,000 titles to offer, there is so much great stuff in the catalog that people haven't watched."

Perhaps. But now that even Blockbuster is throwing its hat into the kiosk ring with its NCR (NYSE: NCR  ) partnership -- with plans to roll out 10,000 kiosks by the end of next year -- Netflix will have to be more sensitive to new-release chasers. That's doubly true since newer titles are rarely available through the company's online streaming service.

Hard questions about Mr. Softy
During the conference call, Hastings noted that Netflix maintains an exclusive deal to deliver digital streams to video game consoles only through Microsoft's (Nasdaq: MSFT  ) Xbox 360. That's an odd choice, since the company has had no problem brokering deals with multiple manufacturers of Blu-ray players to add Netflix streaming to their gadgets.

The Xbox 360 is a great device, but I've always seen it as a bedroom system for diehard gamers. The family-friendly Wii and the Blu-ray-equipped PS3 seem like better fits for the living room, where most folks tend to watch their movies. Could Hastings' seat on Microsoft's board be clouding his judgment? Is the exclusivity deal really in the best interest of Netflix shareholders?

"I'm a major holder of Netflix stock and a very minor holder in relative terms of Microsoft stock," Hastings replied. "I don't think there's an issue there."

Sticking with that theme, my final question had to be about video game rentals, which Netflix has steadfastly shied away from in the past. Despite the success of Gamefly, and Blockbuster's recent interest in similar offerings, Netflix hasn't swayed in its resolve.

"We're focused on being a movie and TV show company -- entertainment video," he says. "That's what our brand is about. We're not focused on games either on the physical rental or on the electronic distribution."

Well said, Hastings -- and well played.

Other Netflix-ish headlines:

Want more perspectives on Netflix? Tune in to this week's Motley Fool Money podcast. New installments arrive after the market close every Friday. Download it at motleyfoolmoney.com or subscribe via iTunes.

Apple, Amazon.com, and Netflix are Motley Fool Stock Advisor recommendations. Microsoft is a Motley Fool Inside Value pick. Try any of our Foolish newsletters today, free for 30 days.

Longtime Fool contributor Rick Munarriz has been a Netflix shareholder -- and subscriber -- since 2002. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy.


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