One time market darling, Netflix (NFLX), released its Q3 earnings report after the market close on Tuesday. Analysts expected it to report 5 cents per share on revenue of $904.4 million. Despite beating both of those estimates with earnings of 13 cents per share and $905.1 million in revenue, Netflix took a tumble after hours due to lower than expected subscriber growth.
In the same period last year, Netflix reported earnings of $1.16 per share on revenue of $812.8 million. This quarter's earnings represent an 89% drop in profit year-over-year as the stock has fallen from a high of nearly $300 just 15-months ago to around $56 today.
Despite the huge drop in earnings and a stock that has done nothing but go down in price, I see Netflix as a buy at these levels. It is the market leader in a growth industry and companies that have seen success while Netflix is falling are still a long way from catching up to it. In addition, the company continues to expand abroad into markets with high growth potential.
The market has brutally beaten Netflix over the last year and a quarter. It started when it raised subscription prices due to rising licensing fees the company had to pay to content providers. Then there was the Qwikster fiasco, which lost it nearly a million subscribers. When Starz stopped negotiating with Netflix in September of last year, the stock took another dive. The company reported its first negative earnings report in years for the first quarter this year, but still exceeded analysts' estimates. However, the market pushed the stock price back down after Q2 results merely met expectations. Most recently, another fall after Tuesday's earnings report.
It is not just Netflix's missteps and bad breaks that led the market to sour on the one time high flyer. Increased competition from Amazon (AMZN), Hulu, and even Google's (GOOG) YouTube are each carving out niches in Netflix's market. Yet, Netflix is still the clear market leader in the internet video on demand sector.
Many consider Amazon's instant streaming a bonus offer for its Prime service, which offers customers free 2-day shipping on all orders in exchange for a set yearly fee. The selection is not nearly as good as what Netflix has to offer. Where Amazon is able to compete is by offering a large selection of movies and television shows that you can pay to rent or buy on demand, but the content is not available in the Prime instant streaming service. Users are likely to pick Netflix for most of their streaming needs, and use Amazon or Apple's (AAPL) iTunes to pay for and download one off episodes or movies.
Hulu offers users free streaming of the latest episodes of shows offered by NBCUniversal, Fox, and ABC/Disney (DIS). They also offer a paid service, Hulu Plus, which allows subscribers to watch the back catalog of hundreds of shows and stream them to multiple devices. Netflix is able to offer a lot of the same content, certainly the most popular choices, and where Hulu still forces users to watch commercials, Netflix is interruption free. Hulu's advantage is in episodes of current seasons, which Netflix is unable to provide. However, it falls short to Netflix's catalog of movies.
Other internet companies like Google and even Facebook (FB) are stepping into the game as they realize there is still a huge untapped market. Nevertheless, even these big players are staying away from Netflix's stomping grounds. Google offers unique content through YouTube channels and Facebook has made one-off movie offerings to users. They understand the power the Netflix brand has, and have kept their distance.
Netflix has over 25 million streaming subscribers in the U.S. Considering there are around 80 million U.S. households with broadband internet, that means the company has not even captured a third of potential users. And that's just in the United States where it has been operating for 15 years.
Netflix has recently started increasing efforts to expand abroad. In the end of 2010, Netflix became available for streaming in Canada. In 2011, Netflix set its sights on Latin America, and in September started offering services to the entire continent of South America in addition to Mexico. Finally, this January, Netflix started streaming in the UK and Ireland.
These expansion efforts depressed earnings for the company. However, as subscribers grow around the world so too will profits. Bandwidth costs Netflix very little in comparison to licensing fees, so the marginal profit on a new subscriber is extremely high. As Netflix is just starting out in many countries, I expect growth to be significantly faster abroad than it is in the US.
There is one thing that remains a huge drag on Netflix - DVD by mail rentals. Last year, Netflix split its streaming and DVD rental service. If customers wanted both, they had to pay for both and there was no longer a bundled deal discount. The margins for Netflix on DVD rentals are so much lower than the streaming video service because of high postage costs and the cost of a physical product. The company has weaned users off the service for several years, but still offers over 8.6 million households with DVDs.
Netflix will not simply stop providing the service because there is no guarantee that it can convert enough DVD subscribers into streaming subscribers. It still makes a profit on each DVD renter, but the terms the company had to agree to with movie studios have provided a lot of disincentive for new users to subscribe to the DVD by mail service. For example, Netflix must wait 8-weeks from a new release before they can send out a DVD to users.
As DVD subscriber numbers shrink and streaming users grow, Netflix will see an increase in profits as they can order fewer DVDs. Eventually, Netflix will be able to stop the DVD rental service and sell off their DVD inventory. Once they are able to do that, they can grow the business even further, whether it is through content or new markets.
Netflix is not the company it used to be. It's not even the company it was just a couple of years ago. However, the new global reach of Netflix makes it once again poised for growth. It has an attractive brand and product offering that outshines every competitor. It is the big player in the media of the present and future, and it has a stronghold on that position. At a current price around $56, Netflix is a strong growth play.