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Let's Get Real About Netflix (NASDAQ: NFLX)

Written By Briton Ryle

Posted October 17, 2014

Netflix (NASDAQ: NFLX) might be down, but it is certainly not out. The internet-based entertainment provider disappointed shareholders with a poor Q3 report yesterday, missing several key expectations including:family television tv viewing

• 3 million new subscribers globally in Q3 where 3.7 million were expected,

• 1 million new subscribers in the U.S. in Q3, down from 1.3 million new U.S. members in Q3 of 2013

• lower earnings estimates for next year.

As a result, investors punished the company’s stock with a vengeance, as it tumbled $117.59 from the previous close of $448.59 to $331.00 by yesterday’s open – representing a drop of 26.21% overnight. Though the stock did claw-back a little during the session, it still closed down $86.89 at $361.70 for a one-day loss of 19.37%. Ouch!

Yet while the shareholder revolt may not be over just yet, with further downside risk remaining, there is good reason to believe the stock will ultimately climb back up – though it may take a few quarters. Analysts believe the company will remain the dominant player in the streaming entertainment space, even with other content providers unveiling their own competing brands.

While they have lowered their price targets for the stock on the back of slower subscriber growth, analysts remain bullish on Netflix. Where Barton Crockett of FBR rates the stock as market perform with a $425 price target some 17% above the current price, Greg Miller of Canaccord has a $450 target some 24% higher, David Miller of Topeka (unrelated) is targeting $511 or 41% higher, and Richard Greenfield of BTIG has a buy rating with a target of $600 some 65% above the current price.

Just why are these analysts so bullish? Let’s recap some of their arguments.

Simply an Adjustment to Higher Fees

Finding the cause of the company’s slower subscription growth was easy to do, as it has happened before.

“As best we can tell,” Netflix management explained the miss in a letter to shareholders, “the primary cause is the slightly higher prices we now have compared to a year ago. Slightly higher prices result in slightly less growth, other things being equal, and this is manifested more clearly in higher adoption markets such as the US.”

This past May, the company increased the cost of its monthly subscriptions by $1 from $7.99 to $8.99, resulting in fewer new subscribers than had been expected, to which the stock market responded negatively, of course.

The last time the market responded negatively to a Netflix price hike was back in 2011, when the stock plunged from just over $300 in July to $60 in November for a drop of 80% over four months. Will the same happen now? Probably. A comparable scenario would have the stock drop from its $450 pre-report price down to $90 over the rest of this year. Sitting at around $360 now means the retreat might still have a great deal further to go.

“But things are different now.” (Isn’t that the way the bulls always respond?) Only in this case, they may very well be right.

Why Now Might be Different

The price hike back in 2011 dealt Netflix stock quite a blow because it dealt quite a blow to its subscriber base.

“Netflix has lost 800,000 subscribers,” reported the Huffington Post in October of 2011. “The streaming-and-DVD site is down to 23.8 million users as of September 30, 2011, compared to 24.6 million users on June 30, 2011.”

In that iteration of a subscription price hike, Netflix’s subscriber base shrank. Yet this time around, its membership still grew by 3 million new devotees worldwide in Q3.

What is more, in 2011 Netflix was less than half the size it is today with its 37 million U.S. users and 53 million globally. It also has a steady stream of its own in-house programming that is exclusive to its service – you just can’t get it anywhere else.

Regarding the value of such original programming, it is important to note that the drop off in new subscribers this past quarter did not happen as soon as the rate was increased. The company believes this was due to “the large positive reception to Season Two of Orange Is The New Black”, one of Netflix’s most watched original shows.

What this shows is that customers will accept higher prices if the content they are getting is enticing enough. This puts a great deal of power and control back into the company’s hands, where it can counter the negative effect of price increases by producing quality programming – which the company already has in the pipeline. This is one advantage the company currently enjoys which it did not have in 2011.

As well, the company is now much more internationally spread than it was back then, having recently launched its services into Germany, France, Austria, and Luxembourg just last month, incurring one-time expenses that will take time to recoup.

FBR’s Barton Crockett, therefore, considers yesterday’s decline in Netflix’s stock as being due “more to high expectations than a change in fundamentals”. Fundamentally, the company is still growing in both original content and sphere of influence.

And we mustn’t forget that it is still growing in subscriptions. Yesterday’s numbers do not show shrinkage; they still show growth in new members. Only the rate of that growth was a little slower than had been anticipated.

The Bigger Picture

Of course, there are competitors coming out with streaming entertainment services of their own that are expected to continue cutting into Netflix’s market share – which is another reason for the slower than anticipated growth.

Where Netflix dominates the space with 37 million U.S. subscribers, HBO has some 30 million, Amazon Prime has around 20 million, and Hulu Prime has around 6 million. Netflix may be the biggest single player in the space, but its slice of the pie has already been cut down to around 40%.

What is more disconcerting for Netflix investors is that HBO earlier this week announced it will soon be releasing its own stand-alone online streaming programming service HBO Go, while CBS is putting together an online service of its own.

But rather than spell the end of Netflix, all this does is lower the growth projections. For the foreseeable future, Netflix will still sit at the top of the heap thanks to its early head-start over its competitors. At some point someone will come along and bump Netflix out of the top spot, that’s for certain. But it won’t be any time soon.

In the meantime, investors should give Netflix’s stock price some time to adjust down to lower subscription growth projections. Once the stock has been adjusted to the newer rate of growth, its price will climb upward along with its still growing number of subscribers.

It won’t be long – perhaps another 3 to 6 months – when that $1 rate hike will be long forgotten, as viewers sign up for new content that will be spewing out of Netflix like a torrent. After all, the streaming video business is only a service. Programming is the product that customers are using the service for. And Netflix has the lead in both service and product where streaming entertainment is concerned.

Joseph Cafariello