Netflix (NFLX, Financial) is down over 20% since the announcement of Q3 results. Price hikes and disappointing subscriber expectations were blamed for the selloff. The same high expectations that warranted overextended valuation multiples in the first place have come to burn Netflix. Here’s a recap of Q3 figures:
As seen above, the top line and bottom line were in line and beat expectations, respectively. For the upcoming quarter, Netflix sees EPS of 44 cents, half the 85 cents that analysts expected. Such disappointing guidance was magnified due to subscription growth (or lack thereof).
Fewer domestic streaming subscribers registered during Q3 than expected. In 2013, new domestic subscription for the quarter came in at nearly 1.3M. Netflix’s focus on international growth paid off as international growth more than doubled. However, overall subscription growth was up only 11%. Netflix expects to add 4 million streaming subscribers in Q4, around the same number of subscribers the company added in Q4 2013.
International expansion and DVD detrimental to profits
Year over year, Netflix expects Q4 profits to decline approximately 75%. Most of this is partly due to the high costs of penetrating the international market. Marketing to increase exposure will result in negative margins, but at least it has the potential to reward the company in the future. As new Q3 international subscriptions showed, the international expansion is crucial to Netflix’s growth.
Currently, approximately 6M U.S. members still use Netflix’s DVD by mail service, accounting for around 10% of Netflix subscribers. This DVD service added $89M in contribution profit in Q3, or approximately 29% of the total contribution profit earned by Netflix. Therefore, DVDs bring in 29% of the money while only accounting for 10% of total Netflix subscriptions.
DVD’s large presence in contribution margin does not bode well for Netflix future profits. Over the last year, Netflix has lost an average of 290,000 DVD subscribers every quarter. This trend is expected to continue as more people move to online streaming, leaving Netflix with a void worth approximately 30% of their contribution profit.
Netflix’s $1 price hike earlier this year was, in part, applied to increase the contribution profits of online streaming services. This could be analyzed as a response to the incoming costs related to international expansion and decline of DVD contributions. Early assessment shows that the price increase has backfired. Profits are still expected to decline, and the subscription growth figures have been negatively affected by the higher price.
Price for Netflix growth not worth risk
Even after the 20% haircut of Netflix stock, investors are paying stretched multiples for forecasted growth. The slowing subscription growth and downward bottom line revision are two concerning issues that surround Netflix in the short term. Thus far, Netflix’s price hike in response to minimizing the effects of declining profits has not gone as planned. Within the longer term horizon, competition is ramping up as both HBO and CBS have announced their own digital subscription services that will attempt to dethrone Netflix. The volatile market environment of late could bring additional headwinds as momentum names are usually the ones to get hit during flights to safety. All in all, there are too many red flags around Netflix for investors to be paying the crazy multiples that the company is currently carrying.
