A Nosedive for Netflix

Earnings were solid but the DVD rental site's lower profit forecast, due to the cost of shifting to downloads and Blu-ray, sends shareholders scurrying

It has been a good year for Netflix shareholders, until now that is. After riding a 50% spike in the DVD-by-mail company's shares, investors fled in droves on a first-quarter report that showed record sales and profits, but warned of slowing growth and higher costs.

Netflix's (NFLX) stock lost almost a quarter of its value on Apr. 22, one day after the report, despite a strong first-quarter showing. The update fed fears of rising costs from the shift to high-definition DVDs now that the Blu-ray format has won a technology battle that kept many consumers from buying HD disc players. Wall Street analysts also expressed concern that Netflix is investing heavily in infrastructure for its online download business. Netflix has been expanding the selection of movie downloads rapidly and plans to make them available for viewing on TVs in addition to computers later this year.

The company ended the first quarter with 8.2 million subscribers, a 21% surge from a year earlier. Netflix benefited in part from a price increase by Blockbuster's (BBI) Total Access rental-by-mail service. Net subscriber additions totaled 764,000, compared with 481,000 in the year-ago period. First-quarter revenue came to $326.6 million, up 7% year-on-year. Profits totaled $13.4 million, or 21¢ a share, up 7¢ from the first quarter of 2007.

Profits Under Pressure

Customer acquisition costs, a key metric that measures the cost to attract new subscribers, fell to $29.50 per account. That was down sharply from $47.46 a year ago, with the cuts in spending also facilitated by Blockbuster's actions, which cut its own marketing on Total Access.

Still, profits are clearly under pressure. Netflix said its gross operating margin fell to 31.7% in the first quarter, shrinking from 36.1% a year ago. The company also lowered its profit forecast for 2008, saying it now expects to earn between $1.16 and $1.29 a share, down from a range of $1.18 to $1.30 a share issued less than two months ago. Part of the drop in earnings will come from added costs associated with moving to Blu-ray discs. Another is the ongoing build-out of Netflix's online download business.

One response will be to boost fees for next-generation services. Chief Executive Reed Hastings said in a conference call that Netflix will be charging more to rent Blu-Ray discs starting later this year, though he didn't offer specifics. "As you are aware, purchasing Blu-ray DVDs costs more both at retail and wholesale than standard-definition DVDs," Hastings said. As a result, "Consumers are used to paying more for high-definition content in every other channel, including video rental stores, video-on-demand, and cable channels."

Partnerships with Electronics Companies

While higher prices on Blu-ray rentals might scare some customers away, the effect on overall growth may be minimal. Analyst Jim Friedland of Cowen & Co. (COWN) pointed out in a research note published Apr. 22, "Blu-ray subscribers account for a low single-digit percentage of subscribers."

In terms of movie downloads—currently offered free for PC viewing to existing subscribers—Netflix has nearly doubled the selection of titles from 5,000 at the end of 2007, to roughly 9,000 now. This rapid expansion means that costs to build-out the online channel are rising, Friedland says. "Netflix indicated that it eventually plans to charge for its online instant viewing service, but we expect it to remain free until the number of digital titles increases and a number of Netflix-to-TV devices become available," he wrote. Netflix plans to release a set-top box made by South Korea's LG Electronics later this year, and similar partnerships with other consumer electronics companies are expected.

Uncertainty about the costs associated with the download service will remain a concern for the foreseeable future, says analyst Daniel Ernst of Soleil-Hudson Square Research. "We would want to see some comfort on how the digital pricing and digital investment is going to play out," he says. "If they can raise the rates on Blu-Ray and start charging for digital content without losing subscribers I might be more optimistic on the stock. Until they can show that, it's going to be under pressure."

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