Why Did Netflix, Inc. Drop 5% After a Higher-Than-Expected Quarter?

Despite its announcement of international success at the 2016 Consumer Electronics Show, and despite a higher-than-expected quarter, Netflix (NFLX 4.17%) still dropped 5% in just a few hours of trading time after releasing Q4 earnings last week.

In this video segment, Chris Hill, David Kretzmann, and Anthony Arsta go over why the stock's price fell after what seemed like fantastic growth news, what Foolish investors should watch for, and how Netflix may not have realized just how much work and money it will have to commit to turn its international membership goals into reality.

A full transcript follows the video.

This podcast was recorded on Jan. 20, 2016.

Chris Hill: Let's start with Netflix. Fourth-quarter profits came in higher than expected. David, we'd talked recently, you were out at CES and there was a big presentation from Netflix, a lot of talk about their international expansion, and help me understand what's going on with the stock, because they reported after the market closed yesterday, right after they announced, the stock popped somewhere in the neighborhood of 10%. Now it's down more than 5%. That's a pretty big swing when you just factor in the after-hours and just a couple hours of trading so far. First, let's just start with the quarter. Was the quarter as good as the 10% pop? Or was it as bad as the 5% drop we're seeing right now?

David Kretzmann: I think it was a pretty good quarter, when you take it in the long-term context, which is how management is looking at it. They're not so worried about near-term profitability, especially with that international segment. They're focused on expanding quickly, building that presence, and then scaling profits from there. So, on Jan. 1, they crossed 75 million members globally, which is a big number for them. They have 45 million in the U.S., about 30 million internationally. This quarter, they beat their own internal forecast of 5.15 million new members.

They added 5.6 million new members. So the numbers that I think matter for Foolish investors like us, patient, long-term investors, you want to see that member count expand internationally. They have a bigger international addressable market now that they're in 130 more countries, like they announced at CES. Now, their addressable market, in terms of households with broadband Internet connection, is up from 360 million homes to now 550 million homes. So with that expansion of addressable market, they're trying to scale internationally, basically, as quickly as they can.

Hill: Tony, is part of what we're seeing today with Netflix just ... in politics, you hear the phrase "a pox on both your houses." Is part of what we're seeing today just investors saying, "Yeah, I don't care about how good this quarter was, I'm just selling for the sake of selling"?

Tony Arsta: I don't know if that's quite accurate. I think the big issue with Netflix now is that their next trick is going to be much more difficult. They've grown so successfully within the U.S. U.S. streaming is up to about 35% operating margin now, and their goal is to get that to 40%. And the number of subscribers in the U.S. has basically plateaued. It's still growing, but it's not growing nearly as quickly. By the end of 2016, I expect that they'll have more international subscribers than U.S. subscribers, and that's still a money-losing business. It's still an area where they're trying to grow quickly.

But the story now has switched from growing in the U.S. to growing internationally, where there's just more competition, there's more languages you need to write your programs in, there's a lot of other concerns that maybe weren't as relevant when they were only a U.S.-focused company. So I think things are just getting more difficult for them. If they continue to grow and get the same market share internationally as they have in the U.S., it'll be a great investment. But that's a much more difficult trick to pull off.

Hill: Have they given any sort of a timeline or even a time frame for when they expect some of these bigger international markets to start turning a profit? And I don't own shares of Netflix, but Reed Hastings and his management team strike me -- just as someone who watches how companies operate, and watches how management operates -- as a pretty forthcoming bunch of people. For all the praise that's heaped upon Jeff Bezos, nobody has ever accused Jeff Bezos of doing anything other than holding his cards incredibly close to the vest. Netflix executive seem like they're pretty straightforward about, "Yeah, this is how much money we're going to spend this year in content."

Arsta: They do give a lot of information, and my problem with Netflix was that they always frame it in the way that they want you follow their story. For example, a few years ago, they would always give their churn numbers, so you always knew how many subscribers are being added and how many were leaving.

And then, they decided one quarter that they would no longer give that information. With international, on every call, they give a few country anecdotes of where things are going well, where they've had success, but they don't give full data where you can actually build up your own models. So, they're more open than [Amazon.com], that's fair to say. But they are selective about what they share.

Kretzmann: They have been pretty consistent since they announced that they were going to be more aggressive with international expansion. That was, I think, the middle of 2015, last year. They mentioned that they expect the international segment to become profitable by 2017. And that's stayed consistent even through that announcement at CES where they really ramped up international expansion at, I think, a faster pace than anyone really anticipated. So they're still expecting material global profits beginning in 2017.

Whether or not they get there is the question. At this point, the company has burned almost $1 billion in cash in 2015. Their free cash flow was minus-$276 million in the last quarter. So really, the big question for Netflix is, can they scale quick enough to the point where they can become a cash flow-positive business? I think that's the big question for investors looking out for the next two to three years.

Arsta: I believe, on the call, they said they'll burn about $120 million international per quarter going forward until they get to that breakeven point. They also said that by the end of 2016, early 2017, they'll need to raise more money. It sounds like they're leaning toward debt. Honestly, at this share price, I don't know why they're not doing more equity offering. But at any rate, they'll need more cash in the future.

Hill: This is one of those stocks that some people look at and go right to the P/E ratio, and they say, "My gosh," even on a day like today, when it's selling off a little bit, it's still got a P/E of 270. What is one metric people should use to look at the stock? Because I know neither one of you looks at this and thinks, "Well, P/E, that's how you should be measuring this stock." Tony?

Arsta: For me, it's more looking at a set of beliefs. They've said that by 2020, they can get their U.S. business to 40% margin. If you assume they can get their international business to a similar level, you can look at what percent of international broadband households would need to have Netflix to make it a reasonable investment, and that's somewhere between 25% and 50% of the world with broadband access, who would need to be paying $10-$15 a month. Somewhere in that ballpark would make it a reasonable investment today. The P/E today is, given their efforts not only in international expansion but new content, the P/E today doesn't tell you one way or the other if it's a good investment.

Kretzmann: Yeah, I think you really just have to focus on their addressable market, and how successfully they can capture members around the world. Their pricing is consistent around the world. That was a question I asked some of their PR folks when we had a chance. They had a press day after that announcement at CES, and I was asking them, do they have different pricing for different countries? Because $9.99 or $7.99, in some countries, that's a hefty amount to pay each month. But the pricing, they said, it is remarkably consistent in all these countries around the world. So, for Netflix to pay off for investors within five to seven years, they'll need 200 million or more members, I think. So, that's really, I think, the metric investors should pay attention to.