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Bracing for Netflix's next close-up
It's been a rocky ride for the company lately. Here's what to look for in its earnings announcement.
July 14, 2004: 4:26 PM EDT
By Eric Hellweg, CNN/Money contributing columnist

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SAN FRANCISCO (CNN/Money) - In the past couple of weeks, the market proved yet again that it is a fickle beast.

Internet bellwether Yahoo! (YHOO: Research, Estimates) reported a strong quarter, at least by most conventional measures, and yet it just...wasn't...good...enough.

Likewise, online DVD-rental company Netflix (NFLX: Research, Estimates), which will announce its second-quarter earnings tomorrow, saw its stock price plummet more than 10 percent on July 2. The reason? It reported that in spite of its $2-a-month subscription-price increase, its overall subscriber numbers increased by 82 percent from a year ago.

Netflix added 163,000 new customers in the most recent quarter, finishing with 2,093,000 -- right in the middle of its previous guidance of between 1,935,000 and 2,140,000 subscribers.

As the late, great Marvin Gaye might ponder, "What's going on?" A couple of things. Stocks such as Netflix and Yahoo! (especially Netflix) are priced in large part on the presumption that they are in a fairly boundless growth cycle. Any signal that these companies are, well, grounded in reality usually meets with investor disdain. Not exactly a healthy response.

Simply put, growth investors wanted to see even more subscriber growth than Netflix delivered.

People want to be wowed

"People expect these companies to beat the numbers," says Safa Rashtchy, a senior research analyst with U.S. Bancorp Piper Jaffray. "Growth investors want guidance to be beat." Rashtchy has a "buy" rating on Netflix and does not own shares. U.S. Bancorp Piper Jaffray was involved in the Netflix IPO.

Netflix now sits in this rather vicious cycle. As my colleague Paul LaMonica and I have written before, Netflix is a fundamentally strong company. It offers a great service, runs a terrific logistics operation, and has solid management that believes in treating employees well and doing the right thing when it comes to expensing stock options.

The problem Netflix investors face is not with the company itself, but with the way the valuation has been established. After Netflix first announced in April that it was increasing the price of its basic plan, investors hammered the stock down nearly 20 percent.

When a company announces plans to increase revenue, investors usually rejoice. Not here. The stock has bounced around in anticipation of the earnings announcement, but remains more than 10 percent below its price prior to the subscriber-number announcement.

Ironically, plenty of evidence shows that Netflix's future can be sunny indeed. The DVD player is touted as the fastest-adopted consumer electronics device in history, but the overall penetration for DVD players is only approximately 41 percent, according to Todd Chanko, an analyst with Jupiter Research.

VCRs (remember them?) still enjoy an 87 percent penetration rate in the United States. And Netflix's healthy revenues account for only 3 percent of the overall home video market (which includes both videotapes and DVDs).

What's more, Netflix has thus far been successful at fending off direct encroachments by two major companies (Wal-Mart and Blockbuster). That's no easy task. There's plenty of evidence for upside, folks. No need to panic on this company just yet.

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So what will these excitable investors look for in tomorrow's announcement? Churn, baby, churn. The stock fell hard in April and earlier this month out of fear that customer churn -- and the associated costs to stanch the subsequent revenue loss -- will rise with the Netflix subscription-price increase.

If the churn rates and customer-retention costs explode, look for this stock to fall further. If the churn rate is modest, I think you'll see some red-faced growth investors rushing in to take advantage of the recent dip and scoop up shares.


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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.