3 Takeaways You Might Have Missed When Netflix Reported Earnings

When Netflix (NASDAQ: NFLX  ) reported earnings on Monday night, investors expected big things. Share prices had soared 193% year to date when the report dropped in, but fell 5% on the news. Investors and analysts focused on 0.6 million new domestic subscribers during the quarter, worrying that it was too low a number.

That's the only number you've seen in most Netflix headlines this week, but there's much more to the story. Let's take a look at three important takeaways you may have missed.

Guidance? We don't need no stinkin' guidance!
Some analysts were hankering for more than 1 million new subscribers from the long-awaited extension of Arrested Development alone. Against that backdrop, 630,000 new American subscribers looks like a big miss. You can read it as Netflix losing subscribers this quarter if you back out the banana stand!

But then you're ignoring the company's own guidance for the quarter. Netflix set the guidance range for the second quarter between 230,000 and 880,000 net additions. 630,000 falls in the upper half of that range, which was set with Arrested's debut in mind.

Moreover, you might recall last year's second-quarter report. That time, Netflix shares plunged 25% overnight as seasonal effects held back subscriber additions over the summer. May I remind you how share prices nearly tripled over the next six months, when the fun and profitable half of the yearly growth cycle played out? The same seasonal effects are still in place, holding Netflix back in the summer with a commensurate boost around the holidays.

So the performance didn't blow guidance out of the water, but certainly shouldn't count as a big miss, either. And as a Netflix shareholder, I'm certainly looking forward to the third and fourth quarters this year.

The HBO limit doesn't apply to Netflix
Skeptics often scoff at Netflix's goal to become two or three times the size of Time Warner's (NYSE: TWX  ) premium cable channel HBO. That channel has been bumping against a glass ceiling for years, never breaking through the 30 million subscriber threshold. If a well-established consumer brand with the money and marketing might of Warner behind it can't move beyond this limit, why should we accept 60 million or 90 million as a destination for Netflix?

Well, Netflix is about to cross that illusory threshold. The low end of third-quarter guidance points to 30.4 million American subscribers. Pop goes the glass ceiling, unless you expect management to set unreachable short-term targets.

Don't forget that you're looking at a virtuous cycle. Once Netflix collects enough revenue to cover its content costs, every additional streaming member is almost 100% pure profit. The streaming delivery costs are minuscule.

What does this mean for the long-term growth trend? Here's how CEO Reed Hastings put it on the earnings call:

What happens is by the time we get to 40 million and 50 million, we get the content better and the service better. And so it's not 60 million or 90 million for the current service. It's 60 million or 90 million for the future service that's much improved with maybe a lot more originals and just incredible streaming.

In other words, as Netflix makes more money from higher customer counts, the company will invest this cash in stronger content and better technology. And as long as you're building a better service, why wouldn't you expect subscribers to keep signing up?

Recommendations matter. A lot.
Here's one that caught me by surprise: More than 75% of the viewing hours on Netflix start with the recommendations system.

Room for improvement: My family has varied tastes. Image source: Author's screenshot of current recommendations.

That's a huge number, and it underscores the competitive advantage Netflix built over the last decade or so. In short, Netflix is pretty good at figuring out what you want to see. The company wants to become the ultimate cure for channel surfing, because that would mean gluing your eyeballs to the Netflix screen in a way that traditional TV channels just can't match. No, not even HBO.

It's an extension of what set TiVo (NASDAQ: TIVO  ) apart in the early days. Your channel-surfing taught TiVo's digital recording boxes a lot about your viewing habits, which allowed the box to present a list of recommended content. That guidance is arguably more valuable than the simple ability to record TV shows without worrying about VHS tapes, and is the foundation of TiVo's strategy even today.

Netflix digs even deeper. The company knows what you're watching, just like TiVo, and both systems come with star-based ratings systems. Netflix also combines this information with patterns culled from DVD and streaming customers since the beginning of red mailers. Mass psychology and big data analysis come into play. Netflix doesn't just know what you might like to see right now, but can also predict the kind of content it should buy or produce for people like you in the future.

This is a massive moat. Amazon.com can't match it, because the company has nowhere near the wealth of customer data that Netflix sports. HBO sure can't run in this race until its online HBO Go service gets a decade of operating data under its belt. The same goes for Hulu, no matter which media giant ends up taking control of that service.

TiVo does have a similar data library and aims to exploit it in the next phase of its checkered history. That's the main reason that I still own that stock: There's a solid advantage in play, and TiVo-less cable operators will find it hard to match this high-quality feature.

But nobody else can compete with Netflix's data trove. Not even TiVo. The fact that 75% of viewing hours come from recommendations is evidence that it works. It's an investable advantage that most people ignore.

But now you know. I own Netflix shares, and the stock is one of my most successful CAPScalls to date. This report did nothing to damage my long-term thesis for owning Netflix shares.

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Read/Post Comments (13) | Recommend This Article (3)

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  • Report this Comment On July 24, 2013, at 7:06 PM, AceInMySleeve wrote:

    We're on the same page for the first 2 and they are key to point out. Content costs are not proportional to how many customers Netflix has, only the release window and exclusivity factor into cost and who is bidding against them for it. Therefore it's self-evident that the subscriber leader has enormous advantages.

    My intuition is the technical recommendation system is an easily overplayed factor however. It does not take a lot of data for those systems to achieve pretty much their full potential.

    So Hulu Plus has 4M customers total and Netflix in it's worst quarter of the year adds over a million globally. Not only is Netflix ahead but they are running so much faster than everyone else. I look at Amazon now and they are spending north of a billion dollars to cater to ~10M subscribers, who watch in aggregate 1/30th the total amount of videos, and Amazon gets no incremental revenue from them. Their plan might be to cross market these customers one way or another. I suspect they'd be better off taking that billion and making Prime free, or giving away a different perk entirely.

    People are concerned about HBO but HBO is so tied up with cable they have this seemingly unpassable crevasse to cut loose. And because Netflix's content is so much different it's not like Netflix's success is killing HBO, so the motivation for all the risks simply isn't there.

  • Report this Comment On July 24, 2013, at 7:40 PM, TMFGemHunter wrote:

    Nice timely article. I agree with point 1: growth will re-accelerate seasonally in the next two quarters. As for point 3, I'm a little skeptical like AceInMySleeve. Amazon has been selling DVDs and VHS tapes for a long time, it has been streaming on a pay-per-view basis for almost 7 years (slightly before Netflix started streaming) and the Prime Instant Video service has been up and running for a couple of years now. I don't see much advantage here, but I really don't know.

    On the other hand, I disagree on point 2. Yes, 30 million subscribers is not a "magic number"; I'm sure Netflix will move past there. However, I think Netflix management is either lying or badly mistaken with regard to the "virtuous cycle" argument. Gaining more subscribers allows Netflix to spend more money on content. But that's a far cry from saying that it allows Netflix to actually have more content.

    I firmly believe that the inflation in the content cost per hour or per piece is growing at a much faster rate than the Netflix subscriber base. Hence the loss of Downton Abbey (3X more U.S. viewers last season than Arrested Development's final season), various Viacom shows, and a bunch of movies from Epix, all within Q2.

    To put it another way, Netflix reportedly has 60,000 movies and TV episodes, and global streaming expense was a little over $2 billion last year; that's about $34K per item. House of Cards Season 1 reportedly cost Netflix $50 million for 4 years, which works out to about $1 million per year per episode. That's 30 times more expensive than the "average" Netflix content item.

    The shift towards more exclusive and original content leads to significantly higher cost per piece. Beyond that, Netflix mgmt. has admitted that Amazon and Hulu have become much more active bidders for content, which is also driving up prices. Either Netflix will have to radically cut the number of titles available in its streaming library, or its content cost will start ballooning far faster than the ~20% U.S. membership growth rate.

    Working on a full article for this weekend to cover these issues!

    Adam

  • Report this Comment On July 24, 2013, at 8:37 PM, AceInMySleeve wrote:

    Adam, I think you're leaving out exactly what forces would propel such dramatic price increases. It's common sense that Amazon existing in the market increases prices ceteris paribus. However, how do you know where it is between a little bit and a lot a bit?

    An alternative explanation for dropping content deals is that Netflix has a fixed budget and continuously seeks the contracts that deliver the most value. If they were unwilling to let go certain contracts, then it stands to reason that the price of those contracts would go up though lock-in. By walking away from some deals, and putting the money in to someone else's hand they are exhibiting buying power.

    So I hope you address in your article how you think these companies would monetize the content if\when Netflix walks away from the table. Most of them have shown some healthy improvements in their own metrics specifically because of Netflix, which implies among other things that there wasn't a way to achieve that profitability prior to Netflix, which implies that having Netflix walk away is expensive, which implies negotiating power.

  • Report this Comment On July 24, 2013, at 9:38 PM, TMFGemHunter wrote:

    @AceInMySleeve: the addition of Amazon, and to a lesser extent Hulu, clearly changes the game in my view. Until 2 years ago, there was a virtual monopsony in the streaming content market. Netflix was the only buyer, and content owners appreciated whatever revenue they could get from it, which was all incremental.

    Late last year, Reed Hastings estimated that Amazon was losing $500M-$1B annually on Prime Instant Video. Since then, Amazon has won a number of high-profile content deals, where Netflix was competing (e.g. Viacom). The point is that Amazon is throwing a lot of money into streaming content, and there's no way that a doubling of the amount of money being spent in less than 2 years (which is essentially what has happened) has a less-than-massive impact on content prices. Content owners are monetizing their content by signing deals with Amazon when Netflix walks away.

    I have no doubt that Netflix is seeking the contracts that deliver the most value for its dollars, as you say. However, that's a lot less value than it was getting for those dollars 2 or 3 years ago when it was the only serious player.

    In case you're wondering why I think Amazon can afford to pay more than Netflix: it's that Netflix is managing the domestic business for near-term profitability, not long-term profitability. Amazon can afford to lose $1 billion a year on Prime Instant Video for the next couple of years from a cash flow and balance sheet perspective, and seems willing to do so.

    Netflix by contrast has fairly modest cash flow to begin with, and is investing what little it has in international growth. As a result, the company needs to grow its domestic margins just to remain solvent. In order to do that, Netflix is walking away from key content deals in order to save money. That can work for a time, but over time subscribers will realize that -- as cheap as Netflix is -- they are getting less and less value for their $7.99 a month.

    Adam

  • Report this Comment On July 24, 2013, at 10:24 PM, AceInMySleeve wrote:

    "there's no way that a doubling of the amount of money being spent in less than 2 years (which is essentially what has happened) has a less-than-massive impact on content prices."

    I would challenge that thesis. They aren't competing for exactly the same content. Imagine if they are buying only 10% of what is theoretically streamable right now.

    I'm also not fond of any thesis that says that Amazon is willing to spend money simply because they have money to spend (however common this is -- I lose respect for those that imply it). They have to justify it against the potential returns on that expense. Companies don't just lose money because they can. No one really knows how the future plays out, and Amazon is taking a shot at a HUGE market, which is reasonable. But if the information that is returned from the experiment is negative, they have to adjust to this information.

    Really, the hard boots-on-the-ground research that needs to be done is some kind of objective measurement of quality over time. Somehow every tv series and movie that Netflix has needs to be graphed. We know their increase in spending over time. We don't know exactly what they are getting for it. I would certainly acknowledge certain early deals like Starz were one-offs, but I think there are natural limits to how much can be charged for the content that constrain your thesis that content costs will outrun increases in subscribers.

  • Report this Comment On July 24, 2013, at 10:27 PM, AceInMySleeve wrote:

    Also Hulu was quite a bit ahead when Netflix entered the market. If they intended to shift more towards a Netflix model I'm sure that adds extra pressure. However, until then it's not clear that they are affecting things much.

    Have you seen the web traffic reports that suggest that Amazon gets about 1/30th the traffic of Netflix? How can they long-term justify spending half of Netflix for that when they get no incremental revenue? I feel like they're better off using that capital elsewhere and would not be surprised to see them eventually conclude likewise.

  • Report this Comment On July 24, 2013, at 10:29 PM, AceInMySleeve wrote:

    The internet tends towards a winner-takes-all solution. It's quite a bit different than brick and mortar in this respect. This is how Amazon has such an amazing valuation, but it's also how Netflix has such an amazing valuation.

  • Report this Comment On July 24, 2013, at 10:58 PM, TMFGemHunter wrote:

    Re: Hulu. Hulu launched in March 2008, more than a year after Netflix launched its streaming service. Hulu Plus launched in November 2010, around the same time that Netflix began offering streaming only subscriptions, as I recall. So I don't see how Hulu could have been ahead.

    I believe Amazon views Prime Instant Video as a loss leader meant to entice people to sign up for Prime, because mgmt. believes that users who pay for Prime will buy from Amazon more in order to get as much as they can for their $79. I think even if Amazon had to donate its Prime revenues to charity, it still might charge $79 rather than giving it away for free. There's psychological value in charging customers, because it makes them want to use Prime a lot to get their money's worth.

    The only ways I can see Amazon dialing back its investment are 1) if Wall St. starts demanding "profits now", which I view as fairly unlikely, or 2) if the bulk of the evidence suggests that people who sign up for Prime because of the video service don't buy more items from Amazon.

    Obviously, I don't have inside info on Amazon's strategy regarding Prime Instant Video. This is the best way I can fit the puzzle pieces together in my head.

    Anyway, I've seen the numbers on usage and they don't surprise me very much. But Amazon has barely even marketed Prime Instant Video to date, although they seem to be ramping up now. My guess: they wanted to get the service competitive in terms of content before driving lots of trials.

    As for the content inflation: the two biggest content wins for Amazon this year were the Viacom package and Downton Abbey. Both were on Netflix a few months ago. I'm sure there's not 100% overlap, but most of the deals are relating to content that Netflix and Amazon both want.

    One other thing: the opportunity cost for content providers of an exclusive deal w/Netflix is that it prevents them from making simultaneous non-exclusive deals with Amazon and/or Hulu. It therefore stands to reason that these three companies have to pay at least double the non-exclusive rate to get exclusivity.

    Adam

  • Report this Comment On July 25, 2013, at 3:07 AM, sliderw wrote:

    Can recommendations based on 30 million users be a lot better than recommendations based on just 3 million users? I seriously doubt it.

  • Report this Comment On July 25, 2013, at 3:11 AM, sliderw wrote:

    @TMFGemHunter

    It is not appropriate to say $1M per episode is a lot worse than $34K per episode when the episodes yield very different benefits in terms of viewing hours.

  • Report this Comment On July 25, 2013, at 3:14 AM, sliderw wrote:

    @TMFGemHunter re 'Wall St. starts demanding "profits now"'

    It doesn't. Until it does. Until it doesn't.

    Wall St. changes its mind a lot. :)

  • Report this Comment On July 25, 2013, at 10:05 AM, TMFGemHunter wrote:

    @sliderw: I didn't say that it was worse to pay $1M for a House of Cards episode vs. $34K for an "average" title: just that it was more expensive. HBO has many fewer titles than Netflix and still has 30 million members because what it does have is really good.

    The problem is (to take it to an extreme) if everything Netflix has in the future is something like House of Cards that costs $1M per episode, it could triple its content budget from $2 billion to $6 billion and still only afford 6000 titles (10% of what it has now). The value of those 6000 titles would surely be much more than the value of any 6000 titles in the library today. But would it be enough to draw in 70 million paying subscribers?

    To me, the business case for Netflix eventually having 60-90 million subs while HBO is stuck at 30 million is precisely that Netflix has much more content. However, I think the content library will continue shrinking unless Netflix changes its strategy and decides to grow content spending faster than revenue again.

    Adam

  • Report this Comment On July 26, 2013, at 4:35 PM, AceInMySleeve wrote:

    Thanks for the correction on Hulu. I had it stuck in my mind that they launched first, but that appears wrong. Maybe the recollection I'm looking for is that their marketshare was stronger in the beginning years.

    "The value of those 6000 titles would surely be much more than the value of any 6000 titles in the library today. But would it be enough to draw in 70 million paying subscribers?"

    I very much suspect so. I remember all of Blockbuster used to spend something like 1.5B$ on content. Isn't DVD sales in the 6B-8B$ range? 6B$ is a huge chunk of money.

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