Netflix Shares Lose $1.1B After Q2 Outlook Miss

26 Apr, 2011 By: Erik Gruenwedel

Wall Street darling discovers the flipside of streaming expansion

Live by streaming. Die by streaming.

Netflix shares April 26 closed down more than 9% ($1.1 billion decline) after analysts voiced concerns over the online disc rental pioneer’s foreign expansion plans, streaming content acquisition costs and mounting competition.

The day after reporting strong quarterly gains in subscriber growth, revenue and net income, Netflix said it would lose up to $70 million in the second half of the year rolling out a second international streaming service — $20 million more than previously projected.

Netflix Canada, which launched last summer, posted a $12 million operating loss in the quarter. The company expects the service, with more than 800,000 subscribers, to become profitable by the third quarter.

Michael Pachter, analyst with Wedbush Morgan Securities in Los Angeles, lowered the boom, saying the service would accrue at least $500 million in streaming acquisition costs this year — far outspending comparable cost savings in reduced disc shipments and related handling costs.

Indeed, Pachter, who carries an “underperform” rating on Netflix’s stock, said that when factoring in 40% reduction ($200 million) in postage fees and $200 million reduction in catalog disc title purchases over the next two years, Netflix will still spend $1.5 billion in total net distribution and content costs through 2012.

He said the core Netflix subscriber continues to rent two-to-three discs per month.

“We think it is highly likely that our estimated $1.975 billion in streaming spending [through 2012] will prove quite low, with the potential that streaming content costs would rise sufficiently to erase much of the gains that Netflix bulls expect in the future,” Pachter wrote in a note.

The analyst also expressed concern regarding increased competition from Hulu Plus, Amazon Prime, Google TV, Apple, and Dish/Blockbuster — all who could engage in a bidding war for digital content. Pachter said a bidder could up negotiations by offering rev-share deals on par with the 60% paid by cable VOD or 70% paid by iTunes.

“Should the price of content increase beyond 2012 and subscription prices come under pressure, we could conceivably see Netflix earnings growth stall, and the quality of its content may suffer,” Pachter wrote.

Analyst Ralph Schackart with William Blair & Co. in Chicago said Netflix’s higher churn rate (3.9%) for streaming compared with rental disc (3.8%) underscored the fickleness of new subscribers seeking instant gratification.

Churn is the number of paying subscribers who opt out of the service during a fiscal quarter. Netflix said that beginning in 2012, it would only report net subscriber gains, subscriber-acquisition costs and churn.

“We believe that shares reflect high investor expectations but may not reflect the potential increased risks associated with studios experimenting with new release windows, potential bandwidth caps and an increase in digital competition,” Schackart wrote in a note.

Tony Wible, analyst with Janney Montgomery Scott in New York, told Bloomberg TV Netflix’s “headwinds” in expansion and content licensing are mounting. He downgraded his rating on Netflix shares to “sell” from “neutral.”

Eric Wold, research director with Merriman Capital in San Francisco, remained upbeat on Netflix, saying it would be difficult for competitors to replicate Netflix's content selection and CE device penetration in either a profitable manner (without heavy loss-leading discounting) or with an offering to attract away Netflix subscribers.

“Why would a Netflix subscriber switch to a competing product with less content even for a slightly lower price?” Wold asked in a note. That said, he lowered his earnings estimates for Netflix for fiscal 2011 and 2012.

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