Movie rental titan Netflix (Nasdaq: NFLX) is gearing up for its fourth-quarter earnings report on Wednesday night. A few analysts have decided to update their thinking on the company just before that momentous event, hoping to capture an investable zeitgeist. So what are they saying -- and are they making any sense?
The lead-off hitter
Caris & Co analyst David Miller takes the first swing. Assuming that a lot of Netflix customers have moved down from higher-priced multidisc plans to options with fewer discs in the mail queue or none at all, Miller sees revenue taking a hit but earnings getting a boost. Why? Cheaper plans mean lower top-line sales, but they're also high-margin items for Netflix, so the collected cash should trickle down the income statement. So far, so good -- this guy has been paying attention.
But he also expects the extra moolah to make it all the way to the bottom line. That's where I'd have to disagree. Netflix management's stated goal is to take whatever surplus cash it has floating around and reinvest it in more, longer, fatter, and better streaming licenses. The lines of communication with Hollywood giant Walt Disney (NYSE: DIS) have obviously been wide open lately, and hotlines to Time Warner (NYSE: TWX) and Sony (NYSE: SNE) Pictures should run warm as well. Every time I check up on my own DVD queue, a few more titles have been tagged with the blue "Play" button for instant streaming.
Even without that lever to pull, the company can -- and often will -- shuttle extra money into more advertising and marketing. So even if Netflix makes an unprecedented pile of greenbacks on the revenue and gross profit lines, much of it will be gone before reaching operating profits or net income.
Miller does recognize marketing as "the greatest 'lever' management has to pull," (though I'd posit that it's actually No. 2, after license acquisitions) and notes that management needs to boost 2011 earnings to something like $4.55 per share in order to boost the stock by another 15% or so. Fair enough. The company has delivered earnings above the midpoint of guidance in every single quarter since the March quarter of 2007, and it often exceeds the top end of its own forecast range as well.
Cleaning up
Pacific Crest analyst Andy Hargreaves piles on with a very different view: a "growing lead in streaming" should lead to above-consensus sales and another earnings outperformance. Andy is catching the other leg of the Netflix growth story; he foresees 5 million gross subscriber additions in the fourth quarter, up from 4.1 million in the third quarter.
That's nice, but I'd rather see a forecast for the net number of new subscribers. Those are the people who stick around and start paying for the service, after all. Netflix itself predicts as many as 2.8 million net new customers this quarter, up from 1.9 million in the previous quarter, and 1.2 million in the 2009 holiday quarter.
Importantly, Netflix appears to be getting stickier and stickier -- with each passing quarter, a higher proportion of trial customers appears to stay around for the long haul. In the third quarter of 2009, when streaming looked like a little hobby on the side, 2.2 million gross additions led to about half a million net subscribers. That’s about a 23% rise in net subscribers relative to gross additions. In the last quarter, that ratio was 47%.
If Netflix is on the money with its top-end 2.8 million net additions guidance, and Hargreaves also nailed the 5 million gross estimate, you'd get a whopping 60% rate in this quarter. That's a lot of "ifs," I know, but it's a starting point against which to measure the actual results.
Not all wine and roses
As upbeat as all of this sounds, Netflix is also a richly valued stock, and it needs to deliver the goods in order to support that lofty perch. Analysts in general are split on where the chart will go next, with seven "buy" ratings, eight sellers, and 18 "holds." Our CAPS system gives Netflix two stars out of five, presumably because of the pricey shares.
Also worth contemplating before loading up on Netflix shares or call options is the damage Coinstar (Nasdaq: CSTR) and its Redbox service suffered from its 28-day-delay deals over the holidays. I don't think the same dynamics apply to Netflix, because of its fundamentally different business model, but the proof will be in the pudding on Wednesday.
That said, I own Netflix for the long haul, because I see hidden profits in the mid-to-long-term future, where others may only see restrained earnings. It's kind of like seeing the first generations of the Apple (Nasdaq: AAPL) iPod and buying in because you could imagine the profits that would come from larger, better, and more feature-rich versions down the road.
I don't think Netflix is anywhere near done growing yet, and I also don't believe that most analysts can see what I'm seeing. They'll be sorry for missing out in a couple of years, or even sorrier for selling the stock short.
