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If P/E ratios are your only yardstick for stock values, please go ahead and sell your Netflix (Nasdaq: NFLX ) shares today. This stock's earnings will stay low, low, low for the next few years. If Mr. Market can see through to the profit-focused endgame that this planned growth spurt leads to, P/E values will look astronomical before long. And if not, the stock itself will stay cheap.
That's the big takeaway from last night's second-quarter earnings report. Netflix is committed to rapid international growth for the foreseeable future, profit or no.
Steady as she goes
There's nothing new about this. Netflix has been working this way since nearly forever. Way back when, management simply adjusted advertising and other marketing expenses to achieve the fastest possible growth of its DVD-mailing service.
At any point, the company could have stepped on the brakes, said that enough is enough when it comes to subscriber growth, and just collect bigger earnings thanks to the lower marketing spend. But then Netflix would have stopped at 5 million subscribers, or 10, and left a ton of money on the table.
Instead, Netflix charged ahead to crush would-be rivals Wal-Mart and Blockbuster under a mountain of loyal customers. The strategy worked, and Netflix never had any credible competition in the DVD rentals game. Coinstar (Nasdaq: CSTR ) is mopping up the remains of that fading market now, but physical discs are reaching the end of their rope, like VHS tapes before them -- even Coinstar's Redbox service is looking ahead to a digital future through a partnership with Verizon (NYSE: VZ ) .
And Netflix is running full speed ahead to build a dominant presence on the new battlefield. CEO Reed Hastings stated his intentions, clear as day: "Modeling global earnings for Netflix for the next couple of years is a relatively easy task, because as the U.S. and our profitable international expansion become positive, we'll tend to turn that money around and invest in additional markets."
Pedal to the metal
So there will be a predictable profit pattern, always keeping Netflix close to the breakeven line on a global basis. American cash will fuel international expansion, and when the new markets start to contribute operating income, that cash never reaches the bottom line, either. Instead, Netflix gets more fuel for even bigger and faster expansion plans. "Our basic model is to become profitable again on a quarterly basis as we have last quarter, and expect to this quarter, and then to add an additional international market, which generally drives us negative slightly and then through growth in the profit streams, gets us back to positive," Hastings said. "And that's what meters our rate of international investment, is to stay approximately breakeven or sort of in and out of profitability."
There are two major problems that could keep Netflix away from certain markets: Difficult regulatory and political beasts like China are probably off-limits, and rampant piracy makes other markets tough to crack. Otherwise, Hastings said, "most of the world will have services like Netflix, and we would like to be that service."
So Netflix reported earnings of just $0.11 per share, down from $1.26 a year ago. But revenue jumped 12.6% year over year despite the Qwikster-related slowdown of last fall. Subscriber growth beat management's guidance in the domestic market while falling slightly below international estimates because of stricter payment validation checks in Latin America. Hastings still hopes to get 7 million new American subscribers in 2012.
We'll know more about the next overseas market sometime in the next two months, with the actual expansion taking place in the fourth quarter. In the meantime, Netflix affirmed that mega-blockbusters The Avengers and The Hunger Games are covered by current distribution deals and will become available to American and international subscribers -- as expected. As a reminder, those two movies pulled in $1.5 billion and $680 million in global ticket sales, respectively. They are transformative tentpoles for Walt Disney (NYSE: DIS ) and Lions Gate (NYSE: LGF ) and will spawn a boatload of sequels and spinoffs, all landing in the Netflix bucket at some point.
I'd expect a major marketing push when these monster hits climb into the Netflix distribution window later this year. This is how the company meets that ambitious 7 million goal for domestic subscriber growth.
I'm still a Netflix bull and not the only one. Fellow Fools Dave Meier and John Reeves are investing real money in the stock right now because they can see beyond a few years of low earnings: "We suspect Netflix is at an inflection point in its journey, and we like the new direction it's headed."
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