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When Netflix Inc. (Nasdaq: NFLX) reported earnings Tuesday, it beat estimates for both revenue and earnings per share – but the stock still slumped 12% yesterday.
The reason panicked investors dumped shares was because they learned that new subscribers in Netflix's domestic streaming business fell well short of management's aggressive guidance. Netflix predicted six months ago it would add 7 million streaming U.S. customers by the end of 2012, but it's now on pace to only add 5 million.
Now that NFLX stock is hovering around $60, is the market telling us that the Netflix growth story is over, and you should ditch shares like yesterday's sellers? Or are investors being handed a golden opportunity to buy Netflix at a bargain basement price?
To answer that, let's take a look at what's driving Netflix earnings.
Netflix (Nasdaq: NFLX): Navigating the Numbers
It's clear from Wednesday's sell-off that investors are very sensitive to Netflix subscriber figures.
That was also illustrated with Netflix's huge stock plunge in 2011.
Back in July 2011, when the Netflix share price peaked at just under $305, Netflix discontinued its combined $9.99 unlimited Internet and DVD package and replaced it with a $7.99 Internet streaming plan and a $7.99 DVD rental plan, effectively raising the price of the combined package by 60%.
At the end of June 2011, just before the change, Netflix had 24.59 million unique subscribers (streaming and DVD) in the United States. Angered over what was seen as a huge and unwarranted price hike, Netflix had lost nearly 1 million subscribers by the end of the third quarter of 2011.
Its stock fell 78% that year from July to November.
But consumers have become accustomed to the new prices. At the end of the third quarter, Netflix had 27.51 million unique subscribers-3 million more than in June 2011.
Addressing the downward revision of net new subscriber guidance, Netflix Founder, Chairman, CEO and President Reed Hastings said, "…I would call that more of a forecasting error than anything else…So we own it in terms of a bad forecast. But in terms of actual performance of the business to grow 5 million net adds, domestic, is substantial, and we feel good about that and about the growth next year."
Subscriber numbers weren't the only thing deterring investors this week. Profits were still well below what they were before last year's pricing change.
Netflix Stock Chart
Looking at the third-quarter numbers, Netflix earned $8 million on revenue of $905 million. Earnings per fully diluted share were $0.13, well ahead of the average analyst estimate of $0.05 per share. But this compares poorly with the earnings per share of $1.16 reported at the end of the third quarter of 2011.
During the third quarter, the domestic streaming segment posted a contribution profit of $91 million which was more than offset by the $92 million loss in the international streaming segment. Netflix is incurring upfront costs related to the launch of an Internet streaming service in four Nordic countries during the fourth quarter.
That means the only money Netflix made came from the DVD segment, which, thanks to last year's price hike, posted a contribution profit of $131 million on revenue of $271 million.
In addition, management is putting more emphasis on producing original content, such as the Arrested Development series, which has higher upfront costs than content purchased from third parties.
As a result, management is guiding for negative free cash flow over the next several quarters. Whether the upfront cost of producing original content can be recovered and whether the buzz generated from these shows will attract new subscribers to Netflix are questions that will be answered in 2013.
For the fourth quarter, management is guiding earnings per share between a $0.23 loss and a profit of $0.04, largely due to the upfront costs of launching its Nordic streaming service.
But high costs now will payoff later, as Netflix management sees streaming video as the future of the industry.
The third quarter letter to shareholders stated, "…we think that over time nearly all U.S. households will be broadband households, nearly all video will be Internet video, and that as our content and member experience continue to improve faster than competitors, our long-term domestic market opportunity remains 2-3x that of linear HBO."
And while the additional 5 million streaming customers in 2012 falls short of the estimate, it's still a 20% gain from 2011.
The leverage in Netflix is in the international streaming segment. If the Nordic launch is successful, international streaming profitability should improve through 2013.
At $60, Netflix is trading more than 80% below its July 2011 peak. There seems to be limited downside risk with good long-term support around the $52 to $53 area.
Rather than panicking, investors might do better to see if management's vision for 2013 will play out by buying shares or long-term calls below $60.
Netflix (Nasdaq: NFLX) closed at $60.12 Wednesday, down about 13% year-to-date.
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