Netflix's Dicey 88% Solution

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Oh, so that is why Netflix (Nasdaq: NFLX  ) is hiking prices.

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.

Motley Fool newsletter services have recommended buying shares of and Netflix. Motley Fool newsletter services have recommended buying puts in Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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.

Read/Post Comments (4) | Recommend This Article (6)

Comments from our Foolish Readers

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  • Report this Comment On July 26, 2011, at 12:29 PM, MKArch wrote:

    3.5M subs walked in the quarter and it will probably be close to 4M by the end of the year. To hit their lofty guidance of returning to year over year higher sub growth they'll need to sign up over 7M new subs in Q4. That will be after the much loved price hike. Subs walking continues to grow at a healthy clip. How long can new adds keep making up for subs walking?

    They've eaten through a huge chunk of their potential market in the U.S. already. Do you really think something like 40% of the U.S. broadband market scattered over 43 countries in Latin American and the Caribbean starting from scratch with entrenched competition, low quality broadband service and ubiquitous pirated content is going to make up for a saturated U.S. market? For that matter do you really think they actually negotiated the licenses including local content requirements for 43 countries in a couple of months? If you believe that you probably also love the scripted cc's and pulling churn metrics after 2011 not to mention the reason the lost the Sony content was due to a "dispute" between Starz and Sony. BTW I didn't listen to the sham cc yesterday but I hear they actually had the gall to announce a "follow up question". I'm sorry I missed that part.

  • Report this Comment On July 26, 2011, at 1:13 PM, BioBat wrote:

    When it topped $300 after the price announcement, the time to sell was ripe.

    IMO, 0.4M sub additions for next quarter is being very generous. I wouldn't be surprised to see 0 or even a negative. The magnitude of the price hike alienated a lot of subscribers. I've already switched to Blockbuster's service and transported my entire DVD/BluRay queue over (and added a few games).

    I do believe most of Netflix subs are streaming - a few on streaming only plans but millions more as a nice add on to DVDs. I don't think for a second that most of the current subscribers will be streaming once Sept. 1 rolls around though.

    The next quarter is going to be brutal for Netflix shareholders.

  • Report this Comment On July 26, 2011, at 1:42 PM, Writerjeff2 wrote:

    While I agree with other posters that Netflix will be facing strong headwinds due to its price increase, I am also disappointed with their overall user experience.

    I am constantly presented with recommendations of "movies I might like" that I've never heard of, that I don't believe ever had theater distribution. At the same time I find that many of my old favorites - films that are 5, 8, 10 years old - are not available for streaming.

    So I'm ready to join the ranks of Netflix subscribers who are leaving in droves. And if I don't have the confidence in the company to be a customer, I certainly don't have the confidence to be an owner. I sold my position yesterday, before earnings.

  • Report this Comment On July 27, 2011, at 2:17 AM, fhl wrote:

    I have been a netflix customer for several years, I can't even remember for how long. Definetely more than five years. I have been a loyal customer through little increases here and little increases there. What many people don't seem to take into consideration is that Netflix has been increasing and increasing over the past few years but the service has not necessarily increased or expanded along with the fees. For example:

    New releases are not available on the actual release date. They are not available for 28 days. But we put up with it because the wonderful convenience of no late fees and the movies are delivered to our door. But then....

    They want to reduce postage overhead and want you to stream so they add a little extra for the convenience of streaming, no waiting for mailed DVD's and no postage fees for them. There is a little increase for this convenience.

    There entire collection is not available to stream as some are "DVD ONLY" and it is a lot more than just some of their collection MOST of their collection is DVD only. So you can't just have a streaming package you need their DVD service. So you can choose between stream limited movies now and keep your DVD or dump streaming and go with DVD's only.

    Customers are paying and paying, long standing customers are paying and paying and their is no consideration for that customer base.

    Netflix isn't saying "We, Netflix are going to fund making this the best service available with securing the majority of our collection for streaming and releasing new releases on the date they are new releases by putting the money up front and you will see we can deliver what we promise and you will want to be our customer".

    Rather Netflix is saying, "We need your cash upfront now so that we can later promise you a better variety of streaming and we can begrudgingly keep mailing DVD's to those people we can't seem to break from DVD habit that is costing us more money than we anticipated when we started up this business and especially the streaming."

    Companies should have to FIRST deliver the product not do a price hike as if customers were investing in you to expand your financial position to bargin with Hollywood.

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