It is tough to see why Netflix, which announced a miniscule reduction in its third and fourth quarter guidance, got so hammered in trading this week, losing 10% of its value in the three days running up to the announcement, and then losing another 10% on the day, falling to $26 and a value of $1.6 billion.
The truth is that in the intense focus on US property debt markets, a full blown recession has been predicted and every analyst is trying to work out which stocks are recession proof. A downward revised guidance is seen as an indicator that the company is prone to recession, especially if it makes the mistake of blaming the renewed guidance on consumers spending.
Given that Netflix, which takes orders for DVDs online, and then delivers them rented through the post, is directly at the beck and call of consumer spending, it would seem obvious that it is going to find customers hard to keep and harder still to attract, at least until the US uncertainty over mortgages and all the associated financial collapses, are over.
It said that its third quarter net income and earnings per share, which it reports fully in a few weeks, will be comfortably within its previous guidance, with income between $16 million and $21 million and earnings of $0.26 to $0.34 per share. Excluding the one-time $6.5 million credit given to subscribers related an August service interruption, third-quarter revenue is expected to be above the company’s lower estimate of $343 million.
What people don’t remember is just what a short period you have to go back in the Netflix history to see tiny margins and only just positive net income. This company survives on monthly annuity revenues and although churn on these types of services are notoriously high, the big spend is in keeping enough DVD copies of each person’s rental selections. Rival services fail to do that, and never buy enough of the more popular DVDs, making everyone wait to see the hottest new films.
People order ten or 20 DVDs online, and when they return one DVD get the next one on their list and can keep 2, 3 or 4 DVDs at a time depending on which specific monthly bundle they are on. Other rival services supply ONE of your next few selections, not specifically the next one. It is this type of investment that makes what Netflix does cash intensive, but then again that’s why it has the brand and the customer growth.
Netflix ended the third quarter with approximately 8.7 million subscribers, which was under its low end estimate and this is perhaps where most of the concern is, up just under 300,000 net adds from 8.4 million in the prior quarter. Subscribers grew 23% year on year, but only 3% sequentially.
“Net subscriber growth in July was in line with expectations but August was unusually weak”, said CFO Barry McCarthy. “In September, the business regained momentum with results slightly below original expectations, likely due to the economic climate.” It’s those words that doomed the stock to slump.
New guidance for the fourth quarter is that at least another 250,000 subs will be added down from a minimum estimate closer to 400,000, there is a leeway of 300,000 to its higher estimate, and that’s no real guidance at all. What the company is saying is that additions might be 250,000 or they might be 550,00. This spread is wide and wild and it suggests that there are a lot of influences beyond Netflix’ prediction operating here.
It says revenues will be between $353 million to $359 million, down from $357 million to $367 million and that GAAP net income will fall in the range from $18 million to $23 million, unchanged.
Honestly in the current climate you would only warn if your numbers were going to be further out than that and we suspect that the share price fell on a feeling that there is worse to come.
Netflix has introduced an online VoD streaming service for viewing over the internet and has used it to cement customer relationships rather than selling it as a service separately. It now has 12,000 online selections versus 100,000 for the DVD service.
There will be no update on ARPU, churn or cost of customer acquisition until the company hosts a call on October 20, all of which will gives us a far better indication of whether the company deserved such an aggressive share sell off or not.