Netflix Drops On Better Than Expected Earnings; Is The Stock Overvalued?

Apr.25.12 | About: Netflix, Inc. (NFLX)

Netflix (NASDAQ:NFLX) released its 2012 first quarter earnings report, beat the Wall Street consensus earnings per share estimate and the share price tanked by 15% in after-hours trading. This is a company in transition and it seems to be hard to put a value on the stock. It appears the hot money traders did not like some of the numbers included in the earnings report. The market has known for months that Netflix will be going through several quarters of negative earnings, so it is a little surprising to see this short-term market reaction.

First Quarter Results Recap

Netflix reported a loss of 8 cents per share on revenue of $870 million for the quarter. The Wall Street consensus numbers were a loss of 27 cents per share on sales of $869 million. Streaming subscribers increased to 23.41 million in the quarter, up from 21.67 million in the 2011 fourth quarter. DVD subscribers dropped to 10.09 million from 11.17 million. Netflix reported 3.07 million international streaming subscribers, up from 1.86 million. The domestic and international streaming subscriber numbers were near the high-end of the guidance ranges given with the previous quarter results. DVD subscriber results were better than the guidance range.

Transition To Streaming

Netflix continues to generate the bulk of what it calls contribution profits from the high margin DVD mail business. Content costs for the streaming business are much higher, resulting in a 13.2% profit margin for domestic streaming compared to 45.6% for the quarter from DVD subscriptions. The 2012 first quarter is only the third quarter where Netflix has broken out domestic streaming subscribers - and second quarter with revenue numbers - as separate from the DVD subscriptions with separate profit margins.

The Netflix plan is to increase the profit margin of streaming video with an expanding number of subscribers as the DVD business continues to slowly lose its customer base. New streaming subscribers significantly increase the profitability of the streaming business. From the 2011 fourth quarter to the 2012 first quarter, domestic streaming revenue increased by $31 million and the contribution profit amount grew by $15 million.

The transition from DVD to streaming subscribers is expected to produce a loss in 2012. The current Wall Street consensus number is a loss of 25 cents per share for the year, with 44 cents of loss in the first half of the year. By beating the estimates for the first quarter, the company should be comfortably positive in the second half of the year. The question is whether the company will be $90 to $100 per share profitable.

International results were mixed in the first quarter, and the segment is still a money loser. The company did better than expected in Ireland and the U.K. but has struggled in Latin America. There are several problems in Latin America, including a less developed Internet infrastructure, lack of awareness about video over the Internet and lack of an easily functioning payment system for e-commerce in many countries.

Conclusion

The large price drop due to the earnings report seems to be a reaction to an outcome which has been apparent for quite a while. The reasons why Netflix may be a good investment for the long term, discussed last month, still apply. The question is-- what share price is the appropriate starting point for the potential re-growth of profits. The reaction to Monday 's earnings release seems to say the company must put up better results faster to justify the current valuation.

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