On Monday, streaming video leader Netflix (NFLX 4.17%) 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.
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.
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.
