Netflix: A Dose Of Reality

| About: Netflix, Inc. (NFLX)

Summary

Subscriber growth did not impress.

US price raise will lift churn, can international offset this?

A decision on the DVD business may be needed soon.

One of Tuesday's worst performers is Netflix (NASDAQ:NFLX), after the company's Q1 report was a little underwhelming. The revenue figure was a little light, and subscriber growth also disappointed. Netflix is facing some big challenges this year, and how the company can work through these difficulties will determine whether the stock can rebound from here.

The drawn out price raise for US subscribers is starting to work its way through the system, part of the reason for management guiding to just half a million net adds in Q2, versus 0.9 million in the year ago period. Additionally, the fact that Amazon (NASDAQ:AMZN) has launched a standalone option for Prime Video is making some investors uneasy. With Amazon's balance sheet in much better shape than Netflix's, the battle for content will only get hotter.

While some may be surprised at the US slowdown, I certainly am not. One of my predictions for this year was that Netflix would add less than 5 million US streaming subs. Don't forget that the company will face another headwind during Q3 from the Summer Olympics, which has been given as a reason for light sub adds previously. Average revenues per user will certainly jump thanks to the price raise, so the key question is how much churn will be seen? The US streaming segment remains the profit center for Netflix, and is the near-term key to delivering material profits that have been promised for 2017 and beyond.

While the international business may not be adding as many subs as many had hoped for, it is getting closer to the breakeven point overall. The company's contribution margin percentage for a negative 10.6% in Q2 2016 is the lowest we've seen since Q3 2014. The hardest part for Netflix around the globe is getting programming in more languages, which is necessary for sub growth, but also costly. A weaker dollar in recent months has helped results in the short term, although comparisons to last year still remain tough.

One of the items I follow the most, one that doesn't receive much coverage elsewhere, is Netflix's DVD business. The segment is under 10% of quarterly revenues currently, but still generates almost enough segment contribution profit to offset international losses. The problem is that Q1 saw a nearly $8 million decline in contribution margin, the worst quarter in some time. When allocating other operating expenses and interest costs, the DVD segment is getting much closer to the breakeven part. Netflix is fine losing money internationally where the business is growing, but what will the company do when the shrinking DVD business starts losing money? Management needs to walk a fine line here after past DVD decision flops, because you don't want to anger customers who also subscribe to your streaming business.

Netflix shares are down by about 11% on Tuesday morning, which seems like an appropriate reaction given the revenue and subscriber miss. While the valuation is sky high on a P/E basis, some believe that a company with 81 million global subscribers and leading the streaming revolution is worth its $41 billion valuation. For Netflix to keep that valuation in the long run, and perhaps grow it, management must overcome some key near-term challenges like the US price raise, the growing strength of Amazon, language barriers internationally, and the near-dead DVD business.

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