Did Netflix Stock Deserve a Pounding Last Week?

On Monday, streaming video leader Netflix (NASDAQ: NFLX  ) posted a big jump in Q2 earnings. EPS more than doubled year over year from $0.49 to $1.15, thanks largely to growth in the global streaming subscriber base from 37.6 million to more than 50 million users. Despite this outstanding growth, Netflix stock has taken a beating since the earnings report.

NFLX Price Chart

Netflix 1-Week Price Chart, data by YCharts.

Not surprisingly, Netflix bulls -- including several of my colleagues here at the Fool -- think that this week's sell-off was undeserved. Did Netflix stock deserve to be taken down a peg or two? Or was the stock's slide justified?

Netflix posted strong subscriber growth and EPS growth in Q3. 

Netflix is firing on all cylinders
It would be pretty hard to argue that there was anything objectively "disappointing" in Netflix's Q2 earnings report. Domestic subscriber growth, international subscriber growth, streaming revenue, and EPS all came in ahead of the guidance Netflix provided in April.

Furthermore, while Netflix management expects EPS to drop sequentially from $1.15 to $0.89 in Q3, that still represents solid guidance considering that Netflix will be absorbing some costs from the launch of its new international markets. Moreover, it would still translate to 58% year-over-year EPS growth.

Thus, considering the earnings report in isolation, there was really no reason for Netflix stock to drop this week -- Netflix posted a strong Q2 performance and guidance was also fairly good. However, looking at the earnings-related news in context, the big drop makes more sense.

Netflix stock was on a tear
One thing to consider when evaluating the recent Netflix stock dip is that Netflix shares have been very volatile recently. The stock has moved back and forth within a wide trading range between $300 and $475 during 2014.

NFLX Chart

Netflix YTD Price Chart, data by YCharts.

Prior to the earnings release on Monday, Netflix shares were trading near all-time highs. Even after its poor performance last week, Netflix stock remained more than 30% above where it was three months earlier. In that sense, Mr. Market was quite satisfied with Netflix's performance last quarter.

Some Netflix bulls were being unrealistic
Unrealistic expectations among many bulls have played a role in the recent Netflix stock slide, too. It was very obvious based on Netflix's previous experience launching new international markets that a "major" international expansion would entail a significant short-term drop in earnings.

Nevertheless, some Netflix analysts on Wall Street did not factor the cost of expansion into their financial models. (Or if they did so, they vastly underestimated the impact it would have.) Just in the last few days, the average analyst EPS estimates for the next two quarters have fallen by 10% or more.

Where will Netflix earnings go next?
The volatility of Netflix stock this year shows that trying to predict where shares are headed next is a hopeless task. However, for long-term investors, it's more important to have a handle on Netflix's earnings trajectory -- in the long run, that will determine what the shares are worth.

From this perspective, last week's stock sell-off seems more sensible. CFO David Wells implied during the earnings interview last week that EPS might decline again in Q4. Whether or not EPS will decline again in Q4 depends on the exact timing of Netflix's new market launches and the speed at which Netflix attracts early adopters there.

Netflix's international expansion will pressure earnings due to content cost growth. 

Netflix plans to launch in France, Germany, Belgium, Luxembourg, Switzerland, and Austria in late Q3, and it will only be absorbing content costs in those markets for the time that it is active. If the launch occurs in mid-September, as was the case for Netflix's Netherlands launch last year, Netflix will only be paying a small fraction of a full quarter's content costs.

Q4 will thus be the first quarter that Netflix absorbs the full impact of its international expansion on content costs. Additionally, domestic contribution profit tends to grow more slowly in the second half of the year due to the seasonality of Netflix's business. Combined, these factors will result in a sharp slowdown of year-over-year earnings growth.

Longer-term, the rise of domestic content costs and growing saturation of the U.S. market will make it hard for Netflix to wring out incremental profit gains there. Netflix executives have said on a number of occasions that the current pace of margin expansion may be unsustainable past 2015.

Foolish bottom line
Pulling this all together, it appears that the recent Netflix stock slide may have been justified after all. It's not that there was anything wrong with Netflix's earnings report or the guidance. However, investors had frantically bid up the shares in recent months and had developed unrealistic expectations about Netflix's future earnings prospects.

Netflix shares currently trade for more than 100 times expected 2014 earnings. To sustain such a lofty valuation, Netflix will need flawless execution in its new markets -- and its existing ones. Investors should approach the stock with a healthy dose of caution.

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Read/Post Comments (8) | Recommend This Article (2)

Comments from our Foolish Readers

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  • Report this Comment On July 25, 2014, at 1:35 PM, pauldeba wrote:

    right, sure, because a company that has made $700 million in 16 years deserves a market cap of $25 billion. The chance Netflix ever comes close to realizing even 1/4 of this market cap is about zero.

  • Report this Comment On July 25, 2014, at 2:01 PM, AceInMySleeve wrote:

    My take is the quarter was dull but incrementally positive. In particular, the unmeasurable impact of a 12.5% price increase really should ring bells for people (and you don't even mention it here).

    I would note contribution profit is increasing domestically at ~50% of revenue, and net sub adds continues to increase Y/Y (not Q2 per se but we both know the reason, and it returns again in Q3). Also again, the price increase. So when you talk about wringing out further incremental profits as a challenge, that needs quantification. I understand that's not gonna be in every article but without it the statement is repetitious.

    Nevertheless I do think this is a stock with a lot of future success priced in. I expect it to be worth the investment 5 years from now, but highly volatile.

  • Report this Comment On July 25, 2014, at 2:31 PM, AceInMySleeve wrote:

    Looks to me like plausibly Netflix gets to 40M domestic and nearly 20M international by end of year. What you think?

  • Report this Comment On July 25, 2014, at 2:42 PM, AceInMySleeve wrote:

    btw Adam, in case you missed it:

    http://www.broadbandtvnews.com/2014/07/24/counting-netflix-b...

    The figures are quite different than Alexa (which I would tend to mistrust anyway). It occurs to me at best Alexa can't even measure non-PC traffic and I still don't know who the heck installs that toolbar but it's certainly not on the television.

    Really Latin America is a litmus for non-Euro non-anglophile expansions and if I could just get one thing out of Netflix it would be accurate numbers there.

  • Report this Comment On July 25, 2014, at 8:25 PM, vv234 wrote:

    YES! absoultely.

  • Report this Comment On July 25, 2014, at 11:30 PM, erob1950 wrote:

    Look for a big bounce up next week.

  • Report this Comment On July 26, 2014, at 1:03 AM, notyouagain wrote:

    Hooray for Netflix, but I have trouble trusting their financial statements since they are one of the case histories in 'Financial Shenanigans'.

    They were busted for improperly shifting regular business expenses to the cash flow statement to inflate their net income.

  • Report this Comment On July 27, 2014, at 9:29 AM, TMFGemHunter wrote:

    @AceInMySleeve: I hadn't seen that report; thanks.

    Your sub estimates seem pretty reasonable. The biggest determinant will be how much Netflix decides to spend on marketing in the new territories during the first few months after launch. (And obviously also how receptive the market is to Netflix's offering.)

    The price increase has two offsetting impacts. On the one hand it could drive away some potential new subscribers. But the grandfathering could also reduce churn, because from a psychological perspective it's harder to quit and give up your grandfathered $7.99 status if you think you might rejoin again. IMO, the real impact of the price increase on sub count won't be seen until 2016 when the increase hits existing members.

    I understand your point about the incremental domestic contribution margin. (It looks to be a tad over 45% for the last 4 quarters.) As long as Netflix keeps adding 6.5 million domestic subs a year, it will have no trouble expanding margins... even without a price increase. I'm just skeptical that Netflix will be able to maintain that growth rate for more than a year or two.

    Meanwhile, Netflix has big plans to expand its lineup of originals and bring in the Disney first run movies within the next few years. So I guess I'd say that the increases in content costs seem much more certain to me than the subscriber base growth.

    The price increase obviously does provide a bunch of incremental revenue -- maybe as much as $600 million by 2016. But unless Netflix wants to become like a cable company with annual price increases, investors will have to wait a while before the next price increase. That's when profit growth could really stall out.

    Adam

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