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It's been three months since Netflix, (NFLX 1.21%) last reported quarterly earnings, but the pain is probably still fresh in investors' memories. Shares of the provider of streaming television and movies crashed 20% after last quarter's results and have fallen further since. The post-earnings tumble came as a shock, since Netflix was a premier momentum stock at the time, and the stock was doing well prior to earnings. But investors were particularly disappointed by two areas in the last report: U.S. subscriber growth that fell short of company expectations and mounting losses in Netflix's international business.
Netflix is slated to report earnings again on Jan. 20, and when it does, those two factors will once again be in investors' crosshairs.
Expect slowing U.S. subscriber growth, but that's not entirely a bad thing
Last quarter, Netflix met revenue expectations and managed to beat on earnings, according to average analyst estimates compiled by Thomson Reuters. But domestic subscriber growth was weak. Netflix added 1 million U.S. subscribers last quarter, but this wasn't enough to appease the market because it fell below management's expectations and was lower than the 1.3 million additions in the year-ago quarter.
Netflix has said it expects to add 1.85 million subscribers in the fourth quarter. Once again, this would represent a declining growth rate year-over-year. According to management, the reason why subscriber growth is slowing is largely because of the decision to raise prices. Netflix increased the price for new subscribers by $1 per month in the second quarter. This has resulted in increased revenue, but lower subscriber growth. Domestic streaming revenue grew 25% last quarter, higher than subscriber growth.
But this is not cause for alarm, because management appears willing to trade subscriber growth for revenue growth and improved profitability when it comes to the domestic market. The decision to raise prices was met with a lot of criticism, but ultimately Netflix decided that profitability is a greater concern right now than membership growth. The U.S. is a higher-adoption market, and Netflix management understood that slowing membership growth was going to happen sooner or later anyway. In exchange, Netflix is realizing much higher margins now. In fact, profit margin in the U.S. is expected to be a full five percentage points higher in the fourth quarter, versus the same quarter one year ago.
Plus, investors should know that Netflix still believes there is potential for as many as 60 million-90 million total U.S. subscribers. (It was at about 37 million last quarter.) The long-term growth story remains intact in the U.S., even if subscriber growth slows a bit in the near-term.
Interestingly, the opposite dynamic is playing out in Netflix's international business.
Netflix is unapologetic for international losses
While Netflix is reporting greater profitability but slowing membership growth in the U.S., it's seeing the reverse scenario play out abroad. Subscriber growth is accelerating, but losses are widening. Last quarter, Netflix added more than 2 million subscribers in its international unit. International additions are expected to total 2.15 million this quarter. At the same time, losses are mounting. Netflix expects to lose $95 million in its international segment this quarter, up from just a $57 million loss in the fourth quarter of 2013.
Again, investors should know this is part of the plan. Internationally, Netflix's strategy will mean higher membership additions now, with a transition to profitability in the future. It's still spending a lot of money to invest in subscriber growth, but these markets are at a much earlier stage in their development than the United States. Netflix just launched in France, Germany, Austria, Switzerland, Belgium and Luxembourg in September, which added 66 million households to its potential market.
These costs, while painful in the short run, are a necessary part of long-term growth. If all goes according to plan, Netflix will transition its international business to mimic where the U.S. is now, with tens of millions more subscribers in tow. Once those customers have taken to Netflix, pricing power could follow, along with improved margins. One reason why this goal is attainable is that this formula has been in place for some time, and is working. According to management, Netflix's international markets launched prior to 2014, Canada and the Netherlands, are collectively profitable. Canada, its first international expansion market, now resembles the U.S. in terms of profitability.
Netflix earnings: Don't lose sight of the bigger picture
The bottom line is that while Netflix's stock price reaction was a huge disappointment after last quarter's earnings, management is not concerned strictly with the stock price. Netflix has different goals for its different geographic markets, because the U.S. and the international markets are in different stages of their development. But the strategy is likely to pay off in the long run, even though this may once again hurt the stock when Netflix reports fourth-quarter earnings.
Investors should resist the urge to panic if the stock sells off again. The important point to remember here is that Netflix's business is strong and its long-term growth strategy remains intact.
