I Was Wrong About Netflix

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I didn't want to be right.

Shares of Netflix (Nasdaq: NFLX  ) are getting smacked around, despite delivering another blowout quarter last night.

The pinprick to investor enthusiasm's balloon comes in the form of declining average revenue per subscriber, a worrisome metric that I highlighted three months ago.

Singled out as "the one thing that Netflix is doing wrong," I pointed out the problematic significance of Netflix's subscriber count soaring 35% over the past year, while revenue growth was only climbing 25% higher. Are current subscribers trading down to the cheapest unlimited plan at $8.99 a month, getting by with just one disc out at a time as long as they have access to the streaming smorgasbord? Are new members being wooed by the $8.99 monthly buffet -- and resisting the upsell of higher-priced plans that provide more DVDs or Blu-ray discs?

"Streaming has been Netflix's not-so-secret weapon in this fight, but it might also catch the company in friendly fire," I wrote at the time.

Well, the battlefield rift is widening. Netflix has now topped the 15 million subscriber mark -- 42% ahead of where it was a year ago -- but revenue climbed by a slightly softer than expected 27%.

As my top line gently weeps
The disparity will continue, and it shows in the company's refreshed guidance since its previous outlook from April. At the high end of its new projected ranges for all of 2010, Netflix is bumping its subscriber target 7% higher and its earnings outlook is getting a 9% kick upstairs. Its top-line guidance is flat where it was three months ago.

I was right -- but in the mother of all Hollywood plot twists -- I was also dead wrong.

The top line doesn't matter. Not for Netflix. Not right now. This isn't the game that the company is playing, and as long as the subscribers keep coming and margins keep holding up their end of the bargain, investors shouldn't care.

I didn't get it three months ago, as I was waving warning flags as the stock soared 15% higher the day after its first-quarter report. Color me a contrarian again this time around, as I call out Mr. Market for overreacting to a metric that doesn't matter.

Netflix is quietly amassing an army of couch potatoes. It's the only company that gets it. Apple (Nasdaq: AAPL  ) and (Nasdaq: AMZN  ) have been serving up piecemeal digital rentals for years, but they're not moving the needle. Coinstar (Nasdaq: CSTR  ) will be one to watch, as its Redbox unit unveils its digital strategy later this year.

Let's take it from the bottom
For now, Netflix stands alone. It's doing right by its subscribers, with churn down dramatically over the past year. Subscriber acquisition costs clocked in higher -- an ugly sight given the dip in average revenue per subscriber -- but time will tell if that's an anomaly or a trend worth losing sleep over. File that blinking amber sign away, and let's revisit the metric come October.

Netflix is doing it right because it's not in denial.

CEO Reed Hastings gets it because he knows that the optical disc is dying. Higher postal rates and inventory logistics of physical rentals will be moot, as more consumers embrace web-served flickery. It's not a shock that Netflix's Canadian service that will launch in the fall will only be a streaming service.

A month ago, I got a nudge from the company's corporate communications department when I referred to Netflix as a DVD rental company. I was asked if I can update my descriptor in the future to something along the lines of an "online movie subscription service." See, even Netflix thinks DVD is a dated initialism. 

Under this kind of scenario, can you blame Netflix for placing more emphasis on growing its subscriber base and its digital catalog? Why tworry about getting subscribers to pay more for the fading rental medium of optical discs? Any shrewd investor would follow the margins before following the top line, and Netflix's performance in recent quarters shows it can make more money with people paying less as long as it makes it up in volume.

After all, if Netflix really thought this was a problem, it could easily rectify the trend. Raising prices for its lowest plan or hiking up the plan requirement for unlimited streaming to its original $16.99 a month offering that provides three DVDs out at the same time should do the trick. However, Netflix would lose some movie buffs in the move, and we all know this is not what the company wants to do even if it appears to be simply in an uncontested arms race.

Netflix has a million more subscribers now than it had three months ago -- and that's a million more that any potential Netflix killer will have to swipe away in the future.

So get excited about Netflix's content-delivery partners Akamai (Nasdaq: AKAM  ) and Limelight (Nasdaq: LLNW  ) as more and more subscribers take Netflix up on its streaming. Bet against distribution centers, disc duplicators, or whoever prints out the company's signature red mailers.

Netflix is several quarters away from today's bears. It's the better vantage point and a killer view.

Will Netflix ever stop growing? Will international expansion save the day? Share your thoughts in the comment box below.

Akamai Technologies is a Motley Fool Rule Breakers pick. Apple,, and Netflix are Motley Fool Stock Advisor selections. Try any of our Foolish newsletter services, 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.

Read/Post Comments (17) | Recommend This Article (22)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 22, 2010, at 10:46 AM, Blockbuster1111 wrote:

    This guy can't even say the word Blockbuster. Netflix is way over priced. Anyone with a brain should know that. Blockbuster will surprise the market soon . It's really a no-brainer about it's come back.

  • Report this Comment On July 22, 2010, at 10:57 AM, scottdeb99 wrote:

    Again Reed Hastings is light years ahead of the game. You are right, the dvd has a short life span and the on line game is where its at. In the long run when the bulk of this country is streaming netflix, I don't think shareholders will really care about a premium service.

  • Report this Comment On July 22, 2010, at 11:12 AM, investintexas wrote:

    Netflix IMHO will be a $400 stock in 5 years in more the 100 million homes. That $8.99 all you can stream price is at the current time perfectly priced. I have barely returned my by mail DVD anymore & $8.99 is just low enough that even if I feel I am not using the service enough, I still won't cancel it. The one threat I foresee to Netflix is to be honest a move AT&T & now Verizon made to cap wireless plans, if Broadband carriers follow suit, NFLX could be in trouble.

  • Report this Comment On July 22, 2010, at 11:26 AM, swest2004 wrote:

    I agree with just about everything you said in this article. However, you are definately skirting the edge from your previous articles which was very confident.

    I like that you put true thoughts out there and took a risk. But you made a wrong call yesterday. I think I would say this article is a "good recovery" and backed up by plenty of insight.

    Simple fact is Netflix had a ton of hype because they have over-delivered BUT they are losing income from people dropping to the $8.99 plan AND losing some biz to Redbox as well do to location convenience. Canada will open up a new revenue stream which will help the stock. I will buy if it ducks under $100.

  • Report this Comment On July 22, 2010, at 11:28 AM, BioBat wrote:

    Netflix is gobbling up new customers like Pac-man to pellets. While the revenue growth isn't as high as subscriber growth (due to new subscribers coming in at $8.99 vs many older subscribers with higher priced plans), that's still more subscribers and counting each quarter. Many, if not most, are being lured in by the promise of an expanding streaming network - that's right network. Netflix is slowly cutting the knees out from cable and onDemand services (do you want to pay $5 per movie or $8.99 a month?) creating it's own de facto cable-like network that continues to grow and expand.

    Growth won't continue forever but if the company proves itself in the Canadian market, the UK isn't far behind and after that worldwide expansion into places with much higher broadband penetration than the US and Canada means the company can continue to grow significantly for the foreseeable future.

    I'll wait and see if there's bit more of a pullback and happily add to my Netflix positions while the analysts who have gotten the company wrong for the past 2-3 years continue to do so by short-changing it's vision of what's to come.

  • Report this Comment On July 22, 2010, at 11:37 AM, jhaw wrote:

    I agree with your comments. Netflix is not about maximizing short term revenue. They are about building a huge subscriber base for streaming video, and they are doing it very well. Distribution of physical media is costly and inefficient, and it will decrease in importance as Netflix moves customers to streaming. They want to keep prices low to attract subscribers. As they add more content the value of the streaming service will allow them to increase the price of the entry-level plan. It will be very interesting to see what they charge for streaming in Canada.

  • Report this Comment On July 22, 2010, at 1:52 PM, mcSEfool wrote:

    Does this also mean that we will not see Netflix stock recover over 110 any time soon? Like within the next 2-3 days?

  • Report this Comment On July 22, 2010, at 2:10 PM, mcSEfool wrote:

    I view this company as a technology company but I am not sure what the next leg or catalyst is for this company to take higher? Are most consumers now in the upgrade cycle and getting Blue ray players with Netflix in them? Should Neflix consider to expand its trial to more than initial 30 days, say 3 months if someone gets new Blue ray player?

  • Report this Comment On July 22, 2010, at 2:54 PM, gallerypup wrote:

    Per yahoo finance, 12 month trailing EPS of $2.47 (vs $2.16 est), current 2010 est incl actual 6mo's is now $2.76 and proj 2011 is $3.54. The analysts are always chasing NFLX; so with 15 million subscribers all NFLX needs to do is squeeze ONE DOLLAR out of expense per subscriber per month and bam $15mil x 12mos = $180 mil divided by 52mil shares outstanding and they add $3.46 per share and double the 2011 proj EPS.

  • Report this Comment On July 22, 2010, at 3:37 PM, Fool wrote:

    The results are EXACTLY what Reed Hastings was hoping to see:

    1) More subscribers, and

    2) A push toward streaming video online

    The streaming video doesn't carry any of the steadily-increasing postage charges. I'm tempted to pick up more shares today after the dip. This is all part of NFLX's long-term strategy, which the short-term analysts are oblivious to.

  • Report this Comment On July 22, 2010, at 4:23 PM, samedge wrote:

    I bought NFLX at the Fool's recommendation in 2006 and was not disappointed with it's performance up until April of this year. It wasn't because of the streaming metric you mention above, but instead the staggering rate at which the company was taking on debt.

    I'm miserly when it comes to financial statements, I'll admit it, but the debt/equity ratio for the company nearly DOUBLED for two consecutive quarters (for the record it dropped from 1.62 to 1.34 this quarter). While their quick ratio is very good, as a prudent bullish investor in a young company I need to see how they effectively they manage that quickly snowballing debt before I buy back in.

    I was disappointed to sell when I did, but you've got to stick your parameters and this metric caused me to bail out (up about +500% - thanks, Fool).

  • Report this Comment On July 22, 2010, at 7:45 PM, CMFStan8331 wrote:

    Netflix just gets it. They understand that the lifespan of a company that focuses on current profits and fails to take serious steps to plan for future technological trends is shorter than it has ever been, and that it will continue to shrink for the foreseeable future. I can't think of any company or industry where trying to stand pat and desperately cling to what you've got hasn't led to financial ruin. That RIAA is really making money hand over fist these days, aren't they?

    Netflix also understand the other part of the equation - that to differentiate themselves in the marketplace, it's necessary to offer an easy, pleasant experience at an attractive price to their users. As of right now, they really have no competition in that regard. All major competing services are either far more expensive, more difficult to use with less added value, or (in most if not all cases) both.

    It is true that cable companies may try to raise prices for internet service. However, the cable companies do NOT have a monopoly as ISP's. if they attempt to go beyond minor increases, they risk losing market share to other ISP's at a time when they're also losing TV customers by the score.

    In today's world, the surest way to the poor house is attempting to wring every last dime out of an outmoded business model. Netflix understands that basic fact extremely well, and will continue to prosper as a result.

  • Report this Comment On July 22, 2010, at 7:52 PM, notic4lyf wrote:

    While I can certainly appreciate you admitting your mistake (even if it was sandwiched between not-so-subtle attempts to highlight what you got "right"), I can't help but feel like you're trying to dance your way around Netflix's true valuation. Weren't you the one who publicly blasted them over their decision to start windowing releases saying they were going to drive away all their customers? Now you're effectively saying they have too many customers many of whom are opting for lower-cost plans and putting pressure on their margins. I also don't get how you can say that the top line doesn't matter during their expansion phase when presumably it's the bottom line that we should be ignoring. Revenue is ALL that matters in this case because the less revenue they're generating per subscriber the more elastic the margin. This would in turn hurt their growth which is contingent on them being able to charge higher prices in the future.

  • Report this Comment On July 22, 2010, at 8:34 PM, denofhc wrote:

    What about Blockbuster? It seems to me they've got a good service in direct competition with Netflix.

  • Report this Comment On July 22, 2010, at 8:57 PM, MrArbitrage wrote:

    "the optical disc is dying". That day cannot come soon enough. I hate those things with a passion. I CAN'T BELIEVE THOSE PRIMITIVE PIECES OF GARBAGE ARE STILL IN USE.

    When the economy turns around (after we expunge the current batch of radical Marxists from the historical record) - when it turns around, subscribers will upgrade. It's like retail or advertising markets. People and companies try to get by with less of them but they know they need it and will step it up when they can. When that happens, NFLX will be in an auspicious position.

    I'm no longer long NFLX but I would be buying if I had the liquidity.


  • Report this Comment On July 23, 2010, at 2:29 PM, emptygestures wrote:

    What about Blockbuster??? Pink sheets my friends and too much in debt. Although NCR looks good. I will put my money on CSTR for a blow out quarter on Thursday.

    The optical disc won't be dead for at least 2 more years. Streaming just isn't something the majority of baby boomers are willing to pick up yet.

  • Report this Comment On August 02, 2010, at 3:38 PM, luv2teleski wrote:

    What about those of us who live rural and have slow internet connection? Although we are only 25 miles from the nearest university town, mountains and gravel roads puts us "out there". Our internet connection is through Verizon and even watching You-Tube can be herky-jerky. We cannot stream effectively. We could download movies to storage for later viewing if it did not take too long and if that is available as an option. And no, satellite is not an option for us either...

    Until broadband can really supply those of us who live (and love living) in the middle of nowhere, I want my discs! Still, I may get some stock in bolster my stock in Coinstar!

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