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Netflix, Inc. Could Go Either Way Next Week

Netflix  (NASDAQ: NFLX  ) is set to report its first-quarter earnings results on Monday, and the drama has never been more intense. Since early March, Netflix shares have skidded about 30% on essentially no news. In other words, the momentum bubble that formed in the last year has popped. Still, Netflix shares are up about 100% in the last 12 months.

NFLX Chart

Netflix 1-year stock chart. Source: YCharts.

Given how quickly Netflix rose last year and how quickly it has fallen in the last month or so, investors should expect plenty of volatility after the Q1 earnings report and conference call. If Netflix reports another big earnings beat and strong Q2 guidance, Netflix shares could regain much of the ground they have lost. On the other hand, any stumble could push Netflix stock below $300.

A history of conservative guidance
Recently, Netflix has routinely crushed its earnings guidance. For Q1 2013, Netflix provided EPS guidance of $0.00-$0.23, but the company earned $0.31 per share excluding a one-time debt extinguishment loss. For the following quarter, Netflix projected EPS of $0.23-$0.48, and it ultimately delivered $0.49, again exceeding the top of the range.

For Q3 2013, Netflix projected EPS of $0.30-$0.56 and reported EPS of $0.52. However, the company accelerated some content expenses for accounting purposes in Q3 last year, which reduced pretax profit by $27 million. Without that expense, EPS would have reached roughly $0.80, way ahead of the guidance.

Last year, Netflix's earnings guidance was consistently conservative.

Finally for Q4, Netflix projected that EPS would reach $0.47-$0.73. The company handily beat the top of the estimate range with EPS of $0.78.

A new guidance policy
Based on Netflix's history of consistently beating its guidance in 2013, it is fair to guess that its guidance for the recently ended Q1 2014 was also conservative. However, Netflix just changed its policy around guidance last quarter. Previously, it had given estimate ranges for EPS and other key inputs -- now it is providing point estimates based on its internal forecasts.

In fact, Netflix claims that going forward, its guidance will not be conservative. In the Q4 shareholder letter, Netflix management stated, "This is our raw internal best-guess forecast, so we should land above it sometimes and below it sometimes."

Not surprisingly, Wall Street analysts aren't sure if they should believe this statement. The average analyst estimate of $0.83 is more than 5% ahead of Netflix's official Q1 EPS guidance of $0.78.

Netflix is modeling a slight sequential EPS decline for Q1, which is odd because the company is forecasting strong growth in domestic and international streaming subscribers. There are some potential offsets, though. CFO David Wells noted on the company's January earnings interview that DVD earnings will decline sequentially due to higher usage, while annual salary raises will increase costs.

Rising content costs could offset subscriber growth, reducing EPS growth.

Other factors that could hold back EPS include increased content spending, interest expense for debt issued this year, and the incremental cost of Netflix's paid peering arrangement with Comcast (NASDAQ: CMCSA  ) .

Given that Q4 and Q1 are the strongest quarters for subscriber growth, it certainly seems like Netflix should be able to overcome these small earnings headwinds. A big earnings beat could put a lot of fears to bed. On the other hand, if Netflix's guidance proves to be accurate, it will be the first time in more than a year that Netflix misses the average analyst estimate. This would breed even more concern about Netflix's valuation.

Q2 guidance will be crucial
While Q1 is a seasonally strong period for Netflix, Q2 is the weakest part of the year, as good weather tends to draw people outside and away from their screens. A spring slowdown in subscriber growth is inevitable, but Netflix bulls may be underestimating just how much growth is likely to slow this quarter.

Netflix has previously told investors to expect that Q2 subscriber additions will decline each year (at least domestically). This didn't occur last year, perhaps due to the release of a new season of cult hit Arrested Development on Netflix. However, there is no equivalent growth driver this spring, so it wouldn't be surprising to see Netflix forecast very low subscriber growth.

Analysts are currently projecting that EPS will grow from $0.83 to $1.01 sequentially in Q2. That kind of strong sequential earnings growth seems hard to reconcile with the slow subscriber growth that is characteristic of Q2. (For reference, adjusted EPS did grow $0.18 sequentially from Q1 to Q2 last year, but that included the boost from Arrested Development.)

Pulling everything together
There are two main scenarios that seem most likely to play out when Netflix reports earnings. On one hand, it's possible that Netflix will beat its Q1 earnings guidance by a wide margin, earning EPS of perhaps $0.90. If that occurs, it won't matter if Netflix forecasts weak sequential growth for Q2 -- investors will chalk it up to more conservatism, and the stock could soar.

On the other hand, it's possible that Netflix will post earnings roughly in line with its guidance ($0.75-$0.85) and it will forecast modest sequential EPS growth. If Netflix's Q1 guidance turns out to be roughly accurate, investors won't be able to write off the company's Q2 guidance as conservative.

That could be a toxic mix for Netflix stock. The company will almost certainly post strong earnings growth in 2014 and 2015, but for richly valued stocks, the rate of earnings growth matters a lot. If Netflix's earnings growth appears to be slowing after its rapid expansion in 2013, Netflix stock could still have a long way to fall.

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Read/Post Comments (14) | Recommend This Article (6)

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 16, 2014, at 5:21 PM, Foolonthepill wrote:

    "Netflix, Inc. Could Go Either Way Next Week..." Thanks for your insight, but my 95 year old grandmother could have told me that much without the pomp, pageantry, and pretentiousness.

  • Report this Comment On April 16, 2014, at 6:03 PM, AceInMySleeve wrote:

    Only a fraction of these articles are going to present new info to you if you follow the company, but Adam and Anders regularly deliver the goods.

    For me, I'm most interested in the status of ISP bandwidth negotiations. Secondly, most interested in potential changes to pricing. Thirdly, most interested in international expansion pace (Germany AND\OR France?).

    I suspect the longer term domestic penetration and margins are a question that only get slightly closer to resolution each quarter. They've been trending slightly higher than their own guidance, but few know when the S adoption curve tilts flat.

    It's an interesting question whether NFLX's price deflation is purely MOMO related or some insight the market has to actual business developments that aren't publicly known yet. I suppose the ER helps resolve that.

  • Report this Comment On April 17, 2014, at 9:17 AM, TMFGemHunter wrote:

    I don't think we'll hear anything new about pricing this time around. My guess is that Netflix will want to time any pricing increase for a seasonally stronger period, not the summer doldrums. (Either early fall or Jan. 1, most likely.) If that's the timeline, we're more likely to hear about it in July, or even October.

    In any case, I think they'll end up grandfathering current users until at least the end of 2015.

    I seriously doubt that the market is being driven by any non-public information about Netflix. I really do think it's momentum going both ways.


  • Report this Comment On April 18, 2014, at 5:50 PM, BentMike wrote:

    If they make their guidance, and are short analyst's estimates, and the stock price tanks, that will be a very good time to think about adding shares.

  • Report this Comment On April 19, 2014, at 12:41 PM, TMFGemHunter wrote:

    @BentMike: That depends on the guidance, and where analyst estimates move following earnings. At the moment, while I think there's plenty of long-term earnings growth potential for Netflix, the analyst estimates for the second half of 2014 and 2015 seem too high.

    I think the rate of earnings growth will probably tail off in the near-term due to the start-up costs of new European markets. The real potential earnings growth catalyst would be whenever a price increase hits current members (assuming Netflix memberships are fairly sticky by then, so that there wouldn't be mass cancellations). I think that's unlikely to happen until 2016 due to grandfathering.


  • Report this Comment On April 19, 2014, at 11:59 PM, CMFgdf wrote:

    I don't think Apple's agreement with Comcast is "essentially no news."

  • Report this Comment On April 20, 2014, at 9:14 PM, AceInMySleeve wrote:

    Adam, agreed with your reply.

    One thing I noticed is that Orange is the new Black was given a Q2 release. I suspect that will be viewed by more subs than AD was last year, and may keep the midpoint for subs guidance positive (it's only a matter of time before that turns negative for Q2 as a regular pattern).

    Given January/February were likely the busiest in terms of sub adds, and Mar -> Jun being fairly flat, I wonder if Netflix is using that lower pressure w.r.t ISP negotiations. If come late summer they haven't made some deals I think this becomes a significant issue as growth will only make things worse.

  • Report this Comment On April 20, 2014, at 10:08 PM, Dayo2 wrote:

    Netflix is among the greatest in all these years. We need to support them.

  • Report this Comment On April 21, 2014, at 4:05 AM, CraigWPowell wrote:
  • Report this Comment On April 21, 2014, at 9:10 AM, TMFGemHunter wrote:

    @AceInMySleeve: I noticed that, too. However, it's not quite the same dynamic. There could be some buzz generated by the new season release, but it was already a Netflix show, so presumably most fans are Netflix members. It might help with churn but it's not likely to bring as many new people in.

    By contrast, Arrested Development had a fan base of people who got into the show when it was on Fox. So there was more of a non-member fan base that could potentially be converted into Netflix members.


  • Report this Comment On April 21, 2014, at 10:14 AM, KombatKarl wrote:

    Really? NFLX could go either way? Wow. Thanks.

  • Report this Comment On April 21, 2014, at 11:19 AM, maximusdesimus wrote:

    When did the Fool become concerned about weekly price movements? I do not visit the website as much as I used to, but this seems to be a stray from the core investing philosophy promoted by TMF.

  • Report this Comment On April 22, 2014, at 9:12 AM, TMFGemHunter wrote:

    @maximusdesimus: We are still very much long-term oriented. I certainly wouldn't recommend that investors trade stocks based on one earnings report. However, investors have different risk tolerances, and so I think it's useful with a stock as volatile as Netflix to get some understanding of the key factors that could send the shares one way or the other.


  • Report this Comment On April 22, 2014, at 10:26 AM, Minow wrote:

    TMF should consider adding candle stick charting to their library to balance out their story telling, because you can see money moving in and out of stocks as opposed to some of the static charts being used. The video is fine, but the storyline is....yawn!

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Adam Levine-Weinberg

Adam Levine-Weinberg is a senior Industrials/Consumer Goods specialist with The Motley Fool. He is an avid stock-market watcher and a value investor at heart. He primarily covers airline, auto, retail, and tech stocks. Follow him on Twitter for the latest news and commentary on the airline industry!

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