3 Reasons Netflix Is Getting Clobbered

It isn't a good day to be a Netflix (Nasdaq: NFLX  ) shareholder, though pounded bulls taking advantage of today's drop as a buying opportunity may beg to disagree.

I'm not a buyer this morning. I've been a shareholder since 2002 at a very flattering cost basis, and I am definitely not selling. However, I'm not entirely sold on the value proposition right now.

My fellow bulls will disagree. Even Pacific Crest analyst Andy Hargreaves disagrees. He upgraded the stock after today's tumble, encouraged by Netflix's booming international subscriber growth and sturdy domestic margins.

However, the bulls need to know what the bears are seeing in the numbers and in the company's guidance. Let's go over a few of the reasons why the stock was getting pounded this morning.

1. All roads lead down to $7.99 a month
When a stock that was trading for a little more than $300 nine months ago crashes all the way down into the double digits, it's tempting to view this as a 70%-off fire sale.

The problem is that this isn't the same company that investors bid up to nearly $305 last summer. The stock peaked shortly after Netflix introduced a controversial plan to begin charging DVD-based customers for its streaming service.

There was a disconnect between couch potatoes and the analysts that get paid to understand them. As consumers began fuming about what amounted to a price increase of as much as 60%, analysts were getting giddy about the incremental potential.

I didn't sell my shares at the time. Shame on me. However, I can also say that I wasn't fooled.

"Netflix's decision is brazen, but not as bright as it -- and some bullish analysts -- think it may be," I wrote at the time.

I didn't get it entirely right. I thought at the time that the shallow streaming service would lose out to the full library available to disc-based subscribers.

Analysts saw the pricing shift as a way for Netflix to milk more money out of its users, but they got it wrong. Many members on DVD plans either traded down to fewer discs or canceled altogether. There may be nearly 30 million worldwide Netflix subscribers right now, but only 7 million of them are paying for discs and streams. Instead of inching higher, the average revenue per user is on a downward spiral until it hits $7.99 a month.

Critics got this wrong, too, of course. Can you call this a price hike if the average price per user is shrinking?

2. Kissing off DVD customers is costlier than you think
Netflix has been very upfront about the state of its disc-based business.

"We expect DVD subscribers to decline steadily, every quarter, forever," CEO Reed Hastings told an analyst during January's conference call.

Forget last month's move to acquire the DVD.com domain name. Ignore the fact that Coinstar's (Nasdaq: CSTR  ) Redbox is proving that DVD rentals aren't dead by hiking its guidance earlier this month and recently snapping up NCR's (NYSE: NCR  ) Blockbuster Express disc-flinging kiosk business.

Netflix wants to be all about the streaming. It's a risky strategy. Sure, international expansion is easier without having to open regional distribution centers to process discs. There are no concerns about scratched returns, managing inventory, or fretting about inevitable postage increases.

However, the streaming service isn't perfect. The moat's iffy, as we see how Amazon.com (Nasdaq: AMZN  ) has assembled a 17,000-title digital library in a little more than a year. The margins are also not as awesome as investors were used to on the disc side.

Consider a few chilling nuggets out of last night's report.

  • Even though Netflix attracted nearly 3 million net streaming customers and shed only 1.1 million DVD accounts, revenue dipped sequentially. There are a lot of factors baked into that anomaly, but it's still interesting.
  • Netflix's 23.4 million domestic streaming customers generated $67 million in contribution profit. The much smaller base of 10.1 million disc-based members delivered $320 million in contribution profit.
  • Margins will expand as the streaming service grows, but what about the contraction on the disc end? Netflix may have lost nearly 10% of its DVD customers during the first three months of the year, but the segment's contribution profit fell by nearly 14%.

3. Netflix was crazy-overvalued this past summer
Paid DVD subscribers dipped below 10 million. I figured it would be a good time to check back and see where Netflix was when it topped 10 million accounts for the first time. The announcement came on Feb. 12, 2009. The stock price at the time was just $36.17.

Netflix's DVD business was booming at the time. It had gone from 9.4 million subscribers at the end of December to 10 million in just six weeks. It seems to be losing disc-based members at the same rate, though Netflix expects the net defections to slow (though never stop). Why should Netflix be worth so much more today?

"Streaming," you say -- and that's a very good answer. However, we also have to assess the value of the service. Is $7.99 a month the floor or the ceiling? With Amazon giving a limited catalog away at no additional cost to Prime members and Redbox toiling away with Verizon (NYSE: VZ  ) on a service that will likely also have to undercut Netflix to find an audience, this is going to become a competitive market.

If you see a monthly rate of $7.99 as the floor, you're a bull. If you see $7.99 as the ceiling, you're a bear. If you're somewhere in the middle, do yourself a favor and find a room where the answer is clearer.

Stream on
Motley Fool co-founder David Gardner has been a fan of Netflix as a disruptor for nearly a decade, but there's a new rule-breaking multibagger that's getting him excited these days. Learn more in a free report that you can check out right now.

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

Longtime Fool contributor Rick Munarriz has been a Netflix subscriber and shareholder since 2002. He does not own shares in any of the other stocks in this story. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early.


Read/Post Comments (6) | Recommend This Article (10)

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 April 24, 2012, at 1:14 PM, MonsterFluff wrote:

    why would margins expand with streaming? Content costs are higher and the obligations go out 5 years at staggering amounts and that is depreciated in COGS. It's big compared to DVD depreciation and costs. Do you think the margin increase will come from lower fulfillment costs and if so do you have some numbers?

  • Report this Comment On April 24, 2012, at 1:41 PM, TMFBreakerRick wrote:

    LeKitKat, the company itself pointed out that streaming margins will expand. The content licensing costs are high but largely fixed, so that assumption probably is based on a growing count of streaming subscribers.

  • Report this Comment On April 24, 2012, at 5:04 PM, morrisjd wrote:

    Amazon Prime Content (Free to Prime Subscribers) is limited to a subset of Amazon's catalog. Translation: You wind up paying for the movies you really want to see, or settle for free content that you probably aren't so interested in. With Netflix, you get the whole catalog for the monthly subscription cost which is a known quantity. No bait and switch.

    Jack

  • Report this Comment On April 24, 2012, at 5:41 PM, purman19 wrote:

    morrisjd, Netflix definitely has "bait and switch" as you define it. You pay the monthly charge for the limited streaming service, and if you want to watch something outside of that, you are prompted to sign up for a DVD plan, which is where all the newer and more popular content is. And Amazon Prime has additional benefits as well. I had to make a choice between Amazon and Netflix this year and it was easy, Amazon all the way.

  • Report this Comment On April 24, 2012, at 5:51 PM, alectric wrote:

    The author fails to mention the fact that the large amounts of bandwidth consumed by the streaming service will sooner or later get the attention of the ISP's and they will not sit idly by having to fork out large amounts of capital to build out new capacity for all the Netflix streaming subscribers. Netflix streaming will ultimately lead to the demise of Net Neutrality and you'll see the ISP's, like the wireless companies, start to charge for usage above 5GB per month. That alone will kill the Netflix model.

    I for one have suspended my account for the last 3 months. I find little in their selection which interests me. Old TV shows don't cut it for me. In the meantime, I've been heading over to Redbox for my movies. I imagine a lot of other Netflix subscribers are doing exactly the same. I'll probably cancel the service when the suspension period is over.

    And no, I am not short the stock. I don't hold any position.

  • Report this Comment On April 25, 2012, at 10:59 AM, funspirit wrote:

    Netflix was CRAZY-Overvalued last year. Absolutely.

    But even before earnings, netflix was tarding at 26 times earnings, with a TON of new competition heading its way. Everyone wants a piece of the streaming pie, and there is little Netflix can do about it.

    here is a column that spoke of the competition heading Netflix's way, well before earnings arrived. Cheers

    http://www.richmakesyourich.com/2012/03/can-netflix-swim-pas...

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