Netflix Ready To Tank On Lower Subscriber Growth

| About: Netflix, Inc. (NFLX)
This article is now exclusive for PRO subscribers.

By Larry Gellar

Netflix (NASDAQ:NFLX) is tanking at the time of this writing (Tuesday), and I recommend investors holding on to the stock get out while they still can. While Netflix reported a smaller loss than Wall Street was expecting, the company warned that subscriber growth for its streaming service would slow down in the second quarter. Considering the streaming service was meant to be Netflix's next power play as it moves away from the DVD business, this is perhaps some of the worst news possible.

Speaking of the DVD business, Netflix lost 1.1 million subscribers in that segment during the first quarter, so clearly Netflix has lost its momentum there as well. Investors should note that while the streaming business competes with products from Amazon (NASDAQ:AMZN) and Comcast (NASDAQ:CMCSA), Netflix has also struggled to maintain its DVD business in the face of companies like Coinstar (NASDAQ:CSTR).

Besides the ominous warning about streaming subscriber growth, Netflix CEO Reed Hastings had other interesting remarks. He said the company will not try to sell its DVD business, but it will open up another market in Europe in this year's fourth quarter. In my opinion, Netflix would be better served perfecting its business model before making any more international moves. On the other hand, Mr. Hastings did say that the company should turn a profit in the second quarter and that the first quarter loss was due to start-up costs for opening up new business overseas. That's encouraging, but other problems remain.

Even with the most recent downward movement in Netflix's stock, some of its statistics are simply appalling. For instance, compare Netflix's price to earnings ratio of 29.51 to 17.58 for Coinstar, 13.34 for Time Warner (NYSE:TWX), and 19.55 for Comcast. Here's another one - Netflix's price to sales ratio is 1.76, while Coinstar's is 1.05, Time Warner's is 1.21, and Comcast's is 1.41. And finally, Netflix's price to book ratio is 8.78, compared to 3.65 for Coinstar, 1.18 for Time Warner, and 1.66 for Comcast. The only way that those ratios could be justified is if Netflix had enormous growth potential, but I'm just not seeing it anymore. Furthermore, I would consider Netflix's margins to be only slightly above average - those numbers are 7.06% net profit, 36.34% gross, 37.94% EBITD, and 11.74% operating.

Now let's go back to the earnings report, specifically the Q&A session that Netflix held. I must admit, I found some of CEO Hastings' answers a bit fishy. For example, the first question essentially asked whether seasonality was really the reason why some numbers were a bit lower than expected. CEO Hastings explained that the seasonality effect is larger than it has been in the past because Netflix has more subscribers now, and this is a statement that does indeed make sense. In fact, I could even see how Netflix would be hurt by an unusually warm winter where people did not stay in and watch movies or TV shows as much. Regardless, I think the seasonality argument is being overemphasized, and I still would have liked to see more growth. The main problem is that while Netflix is clearly growing, I just don't know if it's growing fast enough to justify the price ratios I discussed earlier.

Another interesting question from the Q&A session was about Netflix's "churn" or the number of subscribers that decide to end their service. Specifically, the question mentioned how churn levels have increased since Netflix's infamous price increase last year and asked when the company expects these numbers to come back down to historical levels. CFO David Wells explained that users that stay with the service longer tend to churn less, and this certainly makes sense. Regardless, I think the asker of this question implies a great point. Can we really expect Netflix's churn level to come down? I don't think it will for a couple of reasons.

The first problem is that Netflix's streaming service (the company's big focus right now) is more likely to have quitters because of its lack of physical discs. (By the way, this is actually something that CFO David Wells acknowledged.) The other problem is that I can only imagine that the number of distractors for Netflix is going to grow. What I mean by that is that it's only natural for Netflix to experience new and interesting competitors that people are going to keep trying out.

This is what makes it tough to truly develop a base of customers that are going to stay with Netflix forever and never quit. In fact, it's also what made the old Blockbuster's run so impressive. For a long period of time, people would never dream of quitting Blockbuster - after all, who would you go to? With Netflix, though, the number of choices that people could try out instead seems to only be increasing.

One more interesting question from the Q&A session implied yet another problem that Netflix could encounter. As the number of Netflix subscribers increases, it seems reasonable that Netflix's content providers would try to charge Netflix more money for the same content. (After all, the content is more valuable to Netflix as Netflix has more subscribers to please). CEO Hastings explained that the plan is to grow investment in content at a rate slightly lower than revenue growth, and this appears to be the most intelligent way to handle the situation. On the other hand, I think this is an important dilemma that Netflix faces, which is yet another reason why I am skeptical about this stock. Sure, Netflix will grow, but will profit grow fast enough to justify the price to earnings ratio of 29.51? The way I see it, probably not.

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