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Shares of the video rental giant took a hit last night after posting disappointingly mixed quarterly results.
There isn't anything wrong with the service's popularity. Netflix closed out the second quarter with 25.6 million subscribers, 70% ahead of where it was a year ago. Net margins also widened during the quarter, despite mounting overseas losses and the growing tab to keep its streaming catalog growing. Earnings of $1.26 a share -- 58% ahead of last year's showing on a per-share basis -- handily beat Wall Street's expectations of $1.11 a share in profitability. Revenue growth of 52% to $789 million, on the other hand, fell short of the $791.5 million that Wall Street was targeting.
How does Netflix's subscriber growth soar 70% higher while its top line climbs by just 52% during the quarter? You know the answer. Folks are trading down to cheaper plans, and 75% of Netflix's new accounts are opting for the streaming only $7.99 plan.
This could be interpreted as good news, since Netflix doesn't have to worry about the DVD inventory issues and round-trip postal fees that it incurs on its original disc-based service. However, Netflix dashed near-term hopes on that front by admitting that domestic operating margins -- clocking in at an impressive 16.3% during the second quarter -- will revert back to its 14% target.
That will sting. Analysts figured that Netflix would earn $1.09 a share this quarter, but Netflix's guidance calls for net income per share to clock in between $0.72 and $1.07.
Netflix is mindful that its pricing strategy will alienate subscribers who are currently on DVD-based plans that will no long include streaming as a cost-free bonus. It's targeting just 24.6 million to 25.4 million domestic subscribers by the end of the current quarter, implying just 0.4 million domestic additions during the period at the midpoint of its range. That would represent Netflix's weakest quarter in net stateside additions in more than two years. Domestic churn increased to 4.2% in the second quarter. One can only imagine that it will go higher as couch potatoes digest the new pricing strategy.
Netflix recognizes that it's not alone here. It devoted an entire paragraph in its shareholder letter to each of its three rivals -- Time Warner's (NYSE: TWX ) HBO Go, Amazon's (Nasdaq: AMZN ) Prime, and the multi-studio-fronted Hulu Plus. However, it is equally quick to single out its advantage in terms of popularity and catalog breadth.
The current quarter will be critical for Netflix. It sees just 3 million -- or 12% -- of its projected 25 million subscribers trading down to only carrying disc-based plans by the end of the quarter. Does anyone believe that 88% of Netflix subscribers are actually streaming, and -- more importantly -- willing to pay $7.99 a month to continue to do so?
Netflix is barreling toward the mother of all wake-up calls. CEO Reed Hastings has been right more than wrong over the years and clearly deserves the benefit of the doubt. Unfortunately, this snapshot of the company that's just two months away will need to be seen to be believed.
Will 88% of Netflix's subscribers really be paying for streaming by the end of September? Share your thoughts in the comment box below.