If Hollywood thinks film critics are harsh, it should realize they have nothing on Wall Street. Shares of Netflix (NASDAQ:NFLX) were hammered Monday night, even though the DVD rental giant trounced analyst profit targets on healthy subscriber growth and fattening margins.
The market is known to overreact, but there is often a kernel of truth in the hot buttered popcorn of trading gyrations. Yes, earnings came in strong. Netflix earned $0.24 a share, or $0.27 a share before stock-based compensation expenses. Analysts were expecting a profit of just $0.18 a share, and the showing was substantially better than the $0.09 that Netflix had earned a year earlier. Leading the way was a surge in gross margins, now up to better than 37%, as the company closed in on nearly 5.2 million net subscribers by the end of June.
And now, the bad news. Despite a 62% surge in subscriber growth, revenue rose just 46% to $239.4 million as new customers took to lower-priced plans that clearly didn't ding margins. The problem is that analysts were expecting the top line to clock in at $242.6 million.
Coming in a little light at the top will continue, with Netflix aiming for at least $980 million in revenue for all of 2006. Wall Street was perched just above the $1 billion mark.
It gets worse. Churn rate and free cash flow improved over last year's performance but weakened sequentially. Also problematic is that it costs more for Netflix to land new patrons, who in turn are paying less. The company is now paying an average of $43.95 per gross subscriber addition. That is substantially more than the $38.13 tab it was running a year ago or even the $38.47 it reported in the seasonally challenging March quarter.
Netflix always seems to have a dark cloud looming nearby. Two years ago, it took the form of a price war with Blockbuster (NYSE:BBI) and the threat of Amazon.com (NASDAQ:AMZN) launching a similar service. Lately, it's been video on demand, a challenge that intensified last week when CinemaNow and MovieLink announced the ability to burn DVD copies of its digitally delivered downloads.
On the other hand, Netflix is in fine fiscal shape. Despite the 20% plunge during after-hours trading last night, Netflix remains a growing company with a cash mattress of nearly $5 a share. This doesn't mean that investors should forgive Netflix its shortcomings, though. Blast it to bits on those points. Demand improvement in the quarters to come. Don't settle for anything less than a reasonable response as to how the company plans to take on the video-on-demand threat. Don't take a happy ending for granted. By the same token, Netflix was smart enough to take a proactive and refreshingly aggressive approach in keeping Amazon out of the domestic DVD market. Netflix is never the type to back down from a fight, especially if it's a fight worth fighting for.
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Longtime Fool contributor Rick Munarriz is a Netflix shareholder and plans to stay that way. He has been a subscriber and investor since 2002. T he Fool has a disclosure policy. Rick is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early.
