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Less Cash, More Couch Potatoes for Netflix

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Netflix (Nasdaq: NFLX  ) delivered a rare miss on the bottom line last night. Free cash flow declined considerably during its latest quarter. Revenue per subscriber continues its painful decrease.

However, the company's seemingly bloated shares were puffed even higher after the report, as investors warmed up to everything else about Netflix's quarter.

Let's start with the couch potatoes. Netflix closed out September with 16.9 million subscribers, 52% ahead of where it was a year ago -- and 1.9 million members more than it had on its rolls just three months earlier.

Revenue, on the other hand, climbed just 31%. Once again, subscriber growth outpaced top-line performance. Are new members opting for cheaper plans? Are existing subscribers downgrading to the cheapest $8.99 unlimited plan, and milking its popular perk of unlimited online streaming to fill the void of fewer DVDs?

It's probably a combination of both -- but clearly this isn't fatal to the model. Two-thirds of Netflix's subscribers are now streaming from the company's growing digital library, and it's proving to be as sticky -- and as easy a sell -- as CEO Reed Hastings wanted it to be.

Monthly churn made it below 4%, to 3.8%. Subscriber acquisition costs have fallen to $19.81 from $26.86 for every gross addition over the past year.

Sure, it's not enough to save the quarter. Net income climbed just 26% to $38 million, so net margins slipped -- and that's after revenue slowed down, putting its hands on its hips after telling subscriber growth to go ahead without it.

However, Netflix's story has never been about the current quarter. Free cash flow is down. So what? It's the price that Netflix has to pay when it forks over $115.1 million to build up its digital library -- nearly double what it invested during the second quarter and a better than tenfold increase compared with last year's third quarter.

Netflix is running. We can't see the finish line, but it's not here.

Bring on the subs
Think about it. Netflix has added 5.8 million net new subscribers over the past year. Let's check out how subscriber services with larger audiences have fared during their four most recent quarters.

  • DIRECTV (NYSE: DTV  ) in the U.S. has gained 500,000 satellite television subscribers to 18.8 million.
  • Sirius XM Radio (Nasdaq: SIRI  ) has tacked on 1.3 million accounts to service 19.9 million members.
  • Comcast's (Nasdaq: CMCSA  ) video customers have shrunk by 700,000 to 23.2 million.

Let's play out this trend accordingly. Before the end of the year, Netflix will likely surpass DIRECTV's stateside accounts. It'll run past Sirius XM early next year. If Comcast continues to drive in reverse, Netflix may be coasting by the largest cable provider at some point next year.

Streaming out loud
The time to build up an army of couch potatoes is now, and Netflix knows it. Coinstar's (Nasdaq: CSTR  ) Redbox promises to announce its digital strategy this month. Blockbuster may have filed for bankruptcy, but it's merely a reorganization. It's still out there. (Nasdaq: AMZN  ) and Apple (Nasdaq: AAPL  ) continue to aggressively push their piecemeal digital rentals. It's not what the market craves -- obviously -- but they'll continue to ram it down consumer throats until it works.

So now do you see the importance of landing 1.9 million net new accounts? Now can you appreciate a company raising its full-year subscriber guidance -- from no more than 18.5 million three months ago to a range of 19 million to 19.7 million -- while simply tightening its existing top- and bottom-line targets?

Three months ago, investors pounded the stock under similar circumstances. They were spooked by the implication of penny-pinching subscribers, and a company bent on cracking its billfold wide to build up a digital library that it gives away to departing accounts on unlimited plans.

They get Netflix now.

Netflix runs because it knows that this quarter will be a blur in retrospect. Mr. Market finally sees the bigger picture -- and traces of the distant finish line -- too.

What did you think about Netflix's quarter? Share your thoughts in the comments box below.

Apple,, and Netflix are Motley Fool Stock Advisor picks. 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.

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 (4) | Recommend This Article (3)

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 5:14 PM, learneachday wrote:

    Netflix will need to get more servers. I tried to open Netflix in another window, meanwhile this page loaded. Safari gave me a timed out message for Netflix. I logged on to Motley Fool and began writing this message. Now I can see in the window under this one that Netflix is loading.

  • Report this Comment On October 21, 2010, at 5:17 PM, learneachday wrote:

    Oops! I was optimistic. The page loading was "Netflix Site Error". I clicked the NetFlix home page button and am still waiting for Safari to contact Netflix.

  • Report this Comment On October 21, 2010, at 9:06 PM, TMFBreakerRick wrote:

    Yep. Netflix had an outage today. It does outsource its streaming -- largely through Akamai at the moment -- but I don't know the source of the outage.

  • Report this Comment On October 24, 2010, at 3:13 PM, ChrisBern wrote:

    While Netflix may look good in the "long run", which is probably at least 2-3 years out, how will it look in the next few years? I rarely hear mention of the EPIX agreement in these types of bullish articles. Why not? This is an agreement that in and of itself will add $50M/quarter in new expenses. We're going to be seeing serious margin compression and free cash flow dropping precipitously, even in the face of rapid subscriber growth. How can any discussion of NFLX as an investment not talk about these impending costs? Or is the thought that an extra 6-7 million subscribers will come online just for the EPIX content, and will do so almost immediately? That seems optimistic to me.

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