Source: Netflix
Netflix (NFLX -2.52%) stock crashed by more than 19% after the company announced lower than expected subscriber growth in its earnings report last week. Netflix is a particularly volatile stock, and investors in the company should expect big price swings from time to time. However, the recent decline could easily create a buying opportunity for long term investors in Netflix stock.
A thriller
Netflix has been anything but boring over the last several years. The stock was trading in the neighborhood of $305 per share in July of 2011, only to collapse to less than $55 in July of 2012 after the company tried to make some unfortunate changes in its pricing and services, which infuriated a lot of of its customers to the point that many of them decided to cancel their subscriptions.
But management learned from that mistake. The company reversed its decision and repaired its relationship with customers over time. By 2013 Netflix was growing at full speed again, so the stock quickly exploded higher, making new historical highs above $489 per share in the first week of September of 2014.
After such an exponential rise over a relatively short period of time, expectations were certainly quite demanding for Netflix ahead of the latest earnings report. Unfortunately, the company failed to deliver subscriber growth, which is quite an important metric.
Netflix gained a total of 3.02 million new streaming members during the third quarter, below the company's own guidance of 3.69 million net additions for the period. Domestic growth was particularly weak, with only 0.98 million net new subscribers versus 1.33 million expected by the company. International net additions were 2.04 million, also below guidance of 2.36 billion.
Management attributed this slower than expected growth to the price increase that Netflix implemented in May, saying that the impact of the hike was offset for some time by the fact that the second season of Orange is the New Black was a big a attraction for new subscribers by late second quarter and early third quarter.
The good guys always win
It's important to keep in mind that the company still gained more than 3 million subscribers during the quarter; even if below guidance, this is an acceleration versus the 2.73 million subscribers Netflix gained in the third quarter of 2013. The total membership base stands at more than 53 million at the end of the third quarter, and management expects to add 4 million new members in the fourth quarter. When seen in perspective, Netflix is still growing at a considerable pace.
Revenues grew 27.5% to $1.4 billion during the quarter. While domestic streaming sales grew 25% year-over year, international streaming revenue jumped by an impressive 89% versus the same quarter in 2013. International revenue represents approximately 28% of total streaming sales, and this segment is likely to continue increasing its share of the overall sales mix as it outgrows the domestic business over the years ahead. Considering that Netflix still has enormous room for international expansion, the company is well positioned to continue delivering sustained growth in the long term.
Besides, Netflix is doing a great job at increasing profitability. Contribution margin in the U.S. came in at 28.6% during the quarter, a big increase versus 23.7% in the third quarter of 2013. Management believes the company is on track to achieving a contribution margin of 30% in the U.S. in the first or second quarter next year, and it intends to increase margins by 200 basis points per year after that.
Management also said in the earnings press release that markets launched more than a year ago are collectible profitable on a contribution basis, which shows that Netflix is clearly moving in the right direction when it comes to proving its ability to generate growing profitability over time. As Netflix matures in its different markets, sales growth will most likely slow down, but improved profit margins could be a big plus for investors.
In fact, earnings per share during the last quarter came in better than expected in spite of the disappointing subscriber growth. Netflix reported earnings per share of $0.96, while analysts were on average forecasting $0.93 per share, meaning that increasing profitability more than compensated for the shortfall in revenues during the quarter in terms of overall earnings per share.
Netflix versus Amazon and HBO
Competition is always a risk to watch in such a dynamic growth business, Amazon (AMZN -1.35%) has deeper pockets than Netflix, and it has built a big library, with more than 40,000 movies and TV shows available for streaming in its Amazon Prime Instant Video service.
In addition, Time Warner (TWX) recently announced that it will be offering a stand-alone HBO streaming service in 2015. Netflix has always identified HBO as its main competitor, so the latest move from Time Warner has most likely exacerbated investors' risk perception about Netflix.
However, there is no reason to believe that Netflix can't continue thriving in the face of growing competition. In the words of CEO Reed Hastings:
On the consumer side, it's one more channel. So already consumers subscribed to us and Hulu and Amazon and they do pay-per-view and they do DVD and they do cable. So there's so many great sources of entertainment. And consumers subscribe to many of these.
So there's not much of a change in the direct competitive landscape. We and HBO have completely different content. So I don't think it will be a significant impact at the consumer level.
At the end of the day, content is king, and Netflix is building competitive differentiation via a growing library of titles, including widely successful original productions such as House of Cards and Orange Is the New Black. As long as Netflix continues delivering valuable content for a competitively low price, increased competition in the industry is no reason to sell Netflix stock.
The bottom line
This is not the first time that the market has overreacted to negative news from Netflix, and it probably won't be the last one either. However, big declines in Netflix stock have been buying opportunities in the past, and chances are this last dip will turn out the same way.
