It has been the case time and again in recent memory: Wall Street is less about “what you’ve done for me lately” than about “what you plan to do for me next.” That was a lesson served anew Monday to Netflix (NASDAQ:NFLX) which reported decent earnings after the close of markets but disappointed with their forward projections.
After building positive momentum in recent quarters, the movie rental service reported Q1 earnings of $13.4 million or (21 cents a share) on revenue of $326.2million. Less stock compensation related charges, the winter quarter would have yielded 23 cents a share. Those results were a reasonable increase over earnings of $9.9 million (14c/share) on revenue of $305.3 million for the same period a year ago.
The company’s net income for the quarter matched most analyst consensus expectations. On total revenue, analysts were expecting a slightly better result: somewhere between $326.4 to 326.9 million depending on which polling service is referenced.
Total subscribers were also much improved over the year ago period. For Q1 the total was up to 8.24million from 6.8m last year. Churn, the measure of subscriber cancellations, was also improved. The quarter’s churn result was just 3.9%, down from 4.4% a year ago, and also improved sequentially over the fourth quarter which had a churn rate of 4.1%. In the analysts' call, Reed Hastings characterized that as the best in the company’s six years as a public company.
Another positive was subscriber acquisition costs [SAC], the hefty advertising and marketing related expenses Netflix pays to gain new subscribers. For Q1 the result was down to $29.40, a significant decrease from the $47.46 paid last year and even the $34.60 paid for Q4. As with churn, it was the best result in 6 years of being public.
Part of the SAC decrease can be attributed to adjustments in the ad market related to the economy. (Financial services firms that typically pay heavily for Internet advertising have decreased their marketing expenses. That, in turn, has cut demand and lowered prices for ad inventory Netflix might have otherwise paid a premium for.) The drop off in acquisition costs also probably owes to strategy changes at Blockbuster (BBI) that have led to less near-term competition.
Where things soured for Netflix was guidance. Despite raising full year forecasts for total subscribers and revenue (subscriptions are now forecast to be 9.1 to 9.7 million, up from a prior range of 8.9 to 9.5.; revenue is now forecast at $1.35billion to $1.39billion, up from a range of $1.345 billion to 1.385b), the company lowered projections for per share earnings to a range of $1.16 to $1.29 (emphasis on the midpoint of $1.23). Analysts had been expecting about $1.25 a share.
That adjustment along with drops in gross margins (31.7% versus 33.8% in Q4) and slowing growth in the current quarter trimmed more than ten percent off the stock in afterhours trading.
The market’s reaction may prove excessive over a longer time horizon. Part of the earnings shortfall is likely due to future investment that could bring positive results. More specifically, Netflix has been in the process of building a next generation delivery system (Internet streaming instead of DVDs) for more than a year. Today, that streaming service (called "Watch Now") makes more than 9,000 titles available for instant viewing. Content licenses for these titles come at an increased cost (how much so hasn’t been disclosed).
The prospect of this streaming service displacing the core DVD business is a long way off, but the company’s goal is “to be a great Internet movie service by combining DVD by mail with Internet streaming and to grow subscribers and EPS every year.” The aim is to prepare for the future and anticipate an eventual decline in DVD interests. Increasing online content spending is a step in that path, even if sacrificing some Earnings Per Share upside.
CEO Reed Hastings pointed out in the analyst call that more content spending makes the service “become more attractive to consumers, which in turn makes us more attractive to Consumer Electronics partners.” That, in turn, helps secure partners to embed Netflix client software into devices like Blu Ray players and game consoles. These partnerships make Netflix more significant.
Last quarter, LG (NYSE:LPL) was revealed as the first partner in the embedded hardware program. Now, says Hastings, “I can tell you we have LG plus three additional partners actively working on integrating our technology into their products. Three of the four partners are major companies which each sell millions of devices per year and will enable the Netflix functionality in some of those devices likely in Q4 of this year."
The result of these efforts may not positively effect the bottom line for several years but for long term investors it could prove significant.
The soundbyte to close on that point came from Netflix CFO Brian McCarthy. He answered an analyst’s question saying, “absent a competitive threat to the economic wellbeing of the business, which we don’t see, we have the resources to make one large strategic investment and we’ve chosen to make that investment in growing our ability to deliver content over the Internet to TV sets and other devices, in lieu of reinvest doubling down in the physical world.”