October 25, 2011, 12:31 PM

Analysts see a rough road ahead for Netflix

Warnings of upcoming losses send Netflix’s stock plunging 44% in morning trading.

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Yesterday’s report from Netflix Inc. that it lost 805,000 subscribers from the second quarter to the third quarter and that more bad news is likely on the way in the quarters to come only confirmed what many Wall Street analysts were already predicting.

And that is that, after a 14-year run that saw Netflix rise from Silicon Valley startup in 1997 with a notion that consumers would use the Internet to rent movies online for easy home delivery to a company that generated $2.16 billion in revenue in 2010 from a base of about 20 million subscribers, Netflix is an online retailing organization in serious trouble.

The fact that Netflix lost 3.3% of its domestic subscriber base in just one quarter and that its stock is down 44.2% in just a single day to around $74 per share in mid-morning trading, is a chilling sign that Netflix business performance and subscriber problems will only escalate, says industry analysts. Netflix hit an all-time high of $304.79 per share just three months ago.

Not only are subscribers angry, but Netflix now faces extreme competition in the digital entertainment space, including Amazon.com and Walmart.com, says Steve Frankel, an analyst with Dougherty & Co. in Minneapolis who also follows Netflix. “2012 is likely to be ugly,” says Frankel. “Meanwhile, the competitive landscape continues to evolve domestically, with Amazon stepping up its content offering, especially in conjunction with the introduction of its Fire tablet.”

A closer look at Netflix’s performance and results in the third quarter and gloomy forecasts from CEO Reed Hastings indicate that the problems for Netflix are beginning to mount. From a year-over-year perspective Netflix, No. 13 in the Internet Retailer Top 500 Guide delivered respectable growth:

  • Revenue increased 48.6% year over year to $822.0 million from $553.2 million.
  • Net income increased 64.6% to $62.4 million from $37.9 million.

But the real story in the third quarter numbers is how angry Netflix subscribers were about a controversial change in pricing and a short-lived decision to split the company in two units and rename its DVD by mail business as Qwikster. In earlier guidance issued in September Netflix warned investors that it was bracing for a drop in subscribers and for its total U.S. subscriber base to range from 24.6 million to 25.4 million.

The final numbers, however, showed the drop in subscribers was more serious than expected. And Netflix now is warning that more subscriber deflections—and possible quarterly losses—are on the way. Netflix finished the third quarter ended Sept. 30 with 25.3 million total subscribers, including 23.8 million U.S. subscribers and about 1.5 million international subscribers. But the net loss of 805,000 domestic subscribers was about 34.2% higher than the approximately 600,000 U.S. subscribers Netflix was expecting to lose.

In his third quarter remarks to investors, Hastings noted that Netflix made a huge error in judgment in September when it announced—and then quickly reversed—a decision to split into two separate units. Long-time subscribers also remain angry over a decision in July to eliminate a combination DVD-by-mail and unlimited streaming rental plan priced at $9.99 in favor of offering consumers the option to subscribe to either format for $7.99 each. If customers want DVDs by mail and streaming they now have to subscribe to both and pay a minimum of $15.98 per month to have one DVD checked out at a time and access to unlimited streaming.

“We greatly upset many domestic Netflix members with our significant DVD-related pricing changes and to a lesser extent with the proposed and now canceled rebranding of our DVD service,” says Hastings. “In doing so we’ve hurt our hard-earned reputation and stalled our domestic growth.”

In its third quarter earnings commentary, Netflix also warned investors and Wall Street to brace for subscriber cancelations in the next two quarters and for lower revenue and profit. “Our primary issue is many of our long-term customers felt shocked by the pricing changes and more of them expressed that by canceling Netflix than we expected,” says Hastings. “Because of this our revenue and operating profits will be lower than expected. For a few quarters starting in the first quarter we expect the costs of our entry into the United Kingdom and Ireland will push us to be unprofitable on a global business.”

In Q4, Netflix projects revenue to range from $841 million to $875 million and net income from $19 million to $37 million. But the company’s prediction of more bad financial news has some analysts revising their growth projections for the fourth quarter, 2011 and beyond.

William Blair & Co., a Chicago investment banking and equity research company, is forecasting that revenue for Netflix in the final quarter will total about $859 million, down 13% from an earlier projection of $992 million. Revenue for 2011 is now expected to be $3.19 billion, down 4% from an earlier forecast of $3.32 billion, while revenue in 2012 is predicted to be around $3.70 billion, down 17% from an earlier projection of about $4.46 billion.

William Blair also projects Netflix will post net income of $26.9 million and $217.9 million for the fourth quarter and 2011, respectively. But net income is projected to drop about 93% to around $15.2 million in 2012. “Netflix shares have underperformed the Standard & Poor’s 500 significantly since January,” says William Bair analyst Ralph Schakart, who covers Netflix. “Netflix expects to generate operating losses as it invests in new markets and experiences subscriber declines in its high margin DVD business. Going forward Netflix also faces strong competition from larger competitors.”

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