4 Questions Netflix And Their Investors Should Ask

| About: Netflix, Inc. (NFLX)

Summary

Netflix's simple un-grandfathering plan may have had the biggest impact on their Q2 results causing a huge drop in value.

While Netflix maintains strong growth the industry is becoming more competitive with an ambiguous future.

For the next several quarters ahead all eyes will remain on customer growth and Netflix’s churn rate.

Netflix (NASDAQ:NFLX) got hit hard after reporting Q2 results and is still down double-digits. The slowdown in membership growth was the leading cause for the selloff. However, now that the storm has passed, Netflix and their investors need to take a look at the industry and what Netflix's future in it looks like. Here are four questions Netflix and their investors should ask:

What Is The Competition Going To Look Like?

Netflix revolutionized Pay TV, dominating the space and wiping out the old school Blockbuster model. But people tend to see opportunity in other's success, which is what happened with Netflix. We all know that Amazon (NASDAQ:AMZN) has created their own streaming service, but that is far from the only threat Netflix faces. Devices created by Alphabet (NASDAQ:GOOGL) (NASDAQ:GOOG), Roku, etc., have opened up viewers to many different streaming apps which aren't just cheap but free - and isn't that the way of the millennial generation? I think the biggest threat that faces all Pay TV services aren't each other, but the same threat music faced - free. The hardware technology already exists for consumers to steal copyright content and stream almost any movie, show or even live event for free. It's difficult to predict how much of an effect illegal streaming will have on the future of the industry due to a variety of factors. But in a worst case scenario, Netflix and other Pay TV services could face an ugly fate.

Now there is the possibility that I am completely wrong and more and more people won't start stealing content or it will become highly restricted. If that is the case, Netflix is still going to face increased competition from some heavy hitters. Hulu, Amazon, HBO, Showtime, etc., are all direct competitors now. This is not something Netflix has had to face until recently. It is not just about buying old content anymore, but about creating new content. This is not necessarily a bad thing as Netflix has gained original movie and TV show content, however it does signal the evolution of Pay TV service, which shows it is becoming very competitive with strong established players. No matter how you look at it, the Pay TV space is becoming increasingly competitive and the once disrupter is becoming disrupted.

How Successful Will Their Pricing Strategy Be?

As an industry becomes more competitive, pricing strategy usually becomes more competitive. Pay TV should be no exception to this rule. Netflix may only be raising their costs a buck or two but it wasn't received so well by their customers. Their rollout plan to un-grandfather their customers so they can raise their prices might seem like it will simply grow their top line in the short term, but could cost them valuable customers over the long term. Netflix is facing stronger competition now than they ever had before, and raising prices has motivated their existing customers to exit and a possible move to their competitors. One of Netflix's competitors, Amazon, is known for suppressing prices to maintain strong growth and squeeze out their competition.

Competition is heating up and analysts are expecting Netflix to maintain a strong growth rate. While small price increases may seem harmless to the customer and profitable to the company, it is a daring time to begin making changes to their pricing strategy that will cost all their customers more money for the same services. Netflix needs to make sure they have the right pricing strategy that balances and suits their business development and profitability goals.

Is This Just An Overreaction?

At $0.09 per share, Netflix beat Wall Street's earnings estimates by $0.07. Their revenue of $2.105 billion missed estimates of $2.11 billion - which is a miss of about 0.2%. Looking at those numbers head on most investors wouldn't complain and certainly would not panic like they did. So then, why did they? It was because Netflix forecasted global membership increase at 2.5 million and only came in at 1.7 million. That was the blow that really shook investors and caused a selloff. And to make matters slightly worse, Netflix actually hit their gross additions target but lost members when the media reported their plans to un-grandfather their tenured members. As we know, losing existing customers is always the bigger and costlier threat.

So was the selloff an overreaction? Depends on how you look at it. On the one hand the dollars were good, but the underwhelming number of members was highly disappointing. The fact that some of their customers dropped off makes their future bleaker as it can suggest a significant slowdown along their top line. On the other hand, Netflix's plan to un-grandfather customers may ultimately be worth it if the increased revenue from it exceeds the sales lost. It's simply too early to tell how bad Q2 was for Netflix, but Wall Street doesn't respond well to uncertainty, which makes it bad for their stock. Below you can see the slowdown in membership growth for Q2.

Click to enlargeSource: CNBC

Is It Time To Focus On The Bottom Line?

Netflix has consistently shown profitability, however their margins are thin. Their operating margin for the trailing twelve months is an underwhelming 3.3%. Netflix typically hasn't had to worry about their earnings too much as Wall Street's main focus has been on top line growth. Nevertheless, they are not turning positive free cash flow, and while they have room to add more debt onto their balance sheet they probably won't want to. Stockholders' equity is only $2.4 billion, which is small given the company's $38 billion market cap. Their liquidity is fair, but not very strong, which could signal a sign of more debt to come unless they start producing more cash flow.

Conclusion

While I think Netflix has a few questions to ask themselves, investors should also take note and ask themselves whether their stock is under or overvalued. Trading at 268 times earnings and 5 times sales seems pricey, given the competition and slowdown in customer growth. However, a 23.4% 3-year growth rate is enough to keep growth investors motivated. I believe the decline we've seen in Netflix's price this year is probably warranted. The stock was previously trading at more than 8 times sales at the end of 2015, which is a heavy premium to pay given the increasingly competitive landscape of the industry.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.