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Earnings Really Don't Matter to Netflix

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I hate to say, "I told you so," but it does feel good to be right.

In its third-quarter report last night, Netflix (Nasdaq: NFLX  ) seemed to go out of its way to show how closely management's thinking aligns with my theories of how the company is managed. Let's walk through the evidence, point by point:

  • "By every measure, we are now a streaming company that also offers DVD-by-mail," said CEO Reed Hastings. Streaming is not only a top priority for Netflix now, but also the majority of what it does for a living. This outcome was only a question of time ever since the company was started.
  • "Earnings is a managed outcome," said CFO Barry McCarthy. When I tell you that earnings figures don't mean anything for Netflix investors, I'm often rebuffed with reminders of the dot-com bust, of how Sirius XM Radio (Nasdaq: SIRI  ) justify their investments despite a lack of earnings, and similar counter-arguments. But the reality is that Netflix can and does control exactly where its earnings are going to land in every quarter, and it's done by adjusting the twin levers of marketing and content acquisition.
  • Streaming licenses are a fixed cost, albeit one that gets higher every time expiration dates and renegotiations come up. Hence, subscriber growth is how Netflix builds its business, not in terms of a cash hoard but rather in more compelling content that leads to even more subscribers down the road.
  • This phenomenon plays out in the updated guidance: Netflix upped the expected subscriber count and the concomitant revenues, but kept the earnings targets constant. Why? Because any superfluous monies left over toward the end of the income statement will go toward some combination of more marketing and more streaming licenses before hitting the bottom line.

Bigger and bigger
According to network equipment provider Sandvine, Netflix video streams already account for 20% of all Internet bandwidth in America at peak entertainment hours. I bet content delivery providers Akamai Technologies (Nasdaq: AKAM  ) , Level 3 Communications (Nasdaq: LVLT  ) , and Limelight Networks (Nasdaq: LLNW  ) are all ecstatic to serve Netflix given those heavy flows, and are likely to do whatever they can to steal each others' slices of the Netflix pie as the streaming service keeps on growing in volume and importance.

Despite adding 52% more customers over the last year, Netflix is actually spending less on new DVDs and Blu-ray discs that it used to. The DVD era is slowly grinding to a halt, set to be replaced by digital streams in an ever more dominant proportion. Others will try to replicate the Netflix model, and it's not a very hard problem in technical terms -- anybody can start a video-streaming site. (Nasdaq: AMZN  ) and Apple (Nasdaq: AAPL  ) might try their very capable hands at a subscription-based rental model before too long, and will probably carve out their own niches in the market. But how big of a head start can they give to Netflix if they really want to make a difference -- or for that matter, if they want to actually hurt Netflix?

What's next?
You've seen why I fully expect Netflix to triple in five years, and company leaders just stepped in to underscore nearly every one of my assumptions. Yes, the stock looks expensive by traditional metrics, but that's only because nobody has bothered to develop a valuation model based on price to millions of subscribers, or perhaps enterprise value over revenue growth. That's the kind of metric you would need in order to put a fair price on Netflix, and I've done my best to come up with an approximation of such a model. And by those figures, Netflix still looks like a steal.

The Gardner brothers have recommended this stock to Stock Advisor subscribers for six years, multiplying early investments by as much as 12 times the starting price. What more do you need to hear before taking a position in this trailblazer of the digital entertainment era? Share your skepticism in the comments below, if you still have any.

Fool contributor Anders Bylund holds no position in any of the companies discussed here. Akamai Technologies is a Motley Fool Rule Breakers selection. Apple, Amazon, and Netflix are Motley Fool Stock Advisor recommendations. The Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. You can check out Anders' holdings and a concise bio if you like, and The Motley Fool is investors writing for investors.

Read/Post Comments (5) | Recommend This Article (11)

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 October 21, 2010, at 8:47 PM, joshpritchard wrote:

    I feel like the earnings reaction is still playing out... might be early to call a victory. After reading both, I tend to agree more with the coverage by ZeroHedge

  • Report this Comment On October 21, 2010, at 8:51 PM, foolishkids wrote:

    I am an investor and customer of Netflix. I only have one disagreement with you. I believe they would reach triple the stock value in 2 years or sooner.

  • Report this Comment On October 21, 2010, at 9:33 PM, ronbeasley wrote:

    Right, it does sound just like dot com thinking in 1999 - earnings don't matter, only eyes or subscribers, etc. I hope you are right but it is way too risky a bet to make with all the attractive values there are in this market. And the model is too easy to replicate, the barrier to entry is not that high.

  • Report this Comment On October 22, 2010, at 4:11 AM, Kawfeadikt wrote:

    It isn't dot com thinking. The wisdom of the dot coms was to set aside profit to win market share and figure out how to profit later. Netflix is in the position they can manage how much profit they want and anything beyond their expectations can be plowed back into growing the value of the enterprise. The difference is this: Netflix is cash flow positive whereas many dot coms were characterized by their cash burn rate.

  • Report this Comment On October 22, 2010, at 1:31 PM, BioBat wrote:

    As a company, I think Netflix is outstanding and their poised to take the world by storm but that doesn't mean you can ignore financial fundamentals of the stock forever and ever.

    And yes, the dotcom thinking does apply. Netflix is setting aside (some) profit now to win market share. What do you think their free month trial is? It's an effort to grab subscribers and increase market share without any profit. Of the 1.9 million new subscribers this quarter, about half were unpaid subscriptions. Seeing as how good a company they are and how good the service is, I'm willing to be most stick with the company but you don't know for sure. If they start having more of the outages (like yesterday), you can bet streaming only subscribers aren't going to stick around for very long. This isn't the first crack in Netlix armor we've seen recently, nor will it be the last. So far, it hasn't affected them because they've got an extremely high value product (all the movies you could ever want) for a reasonable price ($9/month) but changes in product and price could have an adverse effect. On the other hand, they're a virtual monopoly now (no Hulu, GoogleTV, Amazon and others are not competitors, they're at best poor imitators).

    I do think Netflix could triple in subscribers and revenue 5 years, but even if it did, it's valuation would still be too high at current levels. It's due for at least a bit of a cool off/correction before it picking up steam again. That said, if you bought in cheaply many years ago, there's absolutely no reason to sell your position now but it's not a company I'm comfortable buying at $170 a share.

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