Quick Thoughts: Apple and Netflix – a Taste of Things to Come?

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–       Apple’s disappointment fuels the bear case of increasing competition and tightening margins – consensus estimates will continue to fall.  47.8m iPhones + 22.9m iPads = Not Enough.

–       Broader product lines and faster update cycles will be pitched as opportunity driven, but are competitive responses and will hit profitability harder than analysts expect.

–       In contrast, Netflix crushed expectations, delivering a profit where losses were expected, and increasing total streaming subs by 13%, including 2 million new US customers.

–       Netflix’s big quarter comes before the effect of new original programming, and suggests the company could reach the scale and differentiation needed to survive and win a tough, tough game.

On a revenue basis, Apple has now missed three quarters in a row, the point where an anomaly becomes a trend, decelerating to 18% YoY growth, its slowest rate since mid-2009.  The 47.8M iPhones and 22.9M iPads were disappointing, given whisper numbers that had been creeping upward in the wake of Verizon’s reveal that it had sold 6.2M on its own for the quarter.  Gross margins were down for the third consecutive quarter, off more than 600bp YoY to 38.6%, evidence of the costs of accelerating product development and broadening product lines.  This, too, is a tough trend, one that could continue for a long while given competitive trends and Apple’s likely responses.  Rumors of a spring iPhone refresh and of a broadening product line, including low cost models intended for the ruthless competition of the emerging market are not harbingers of margin stability.  I’ve written about this at length.  (see Apple: Can a Leopard Change its Spots?)

As usual, Apple offered guidance for the quarter ahead, this time confusing the matter by announcing that it had changed its previous policy of giving obviously low-ball guidance.  Analysts who had calibrated their models based on the track record vs. the official guidance will be flying blind for at least one quarter.  If Apple management is being straight about giving accurate guidance, it has the considerable potential of blowing up in their face come April.  More importantly, these same analysts have not universally gotten the message about the decelerating sales and downward trending margins.  Valuation will not matter until the downward revisions are done, and that could take a long time to play out.

Now for the feel-good side of today’s news.  I’m kicking myself for not having added Netflix to our large cap model portfolio when I had the chance.  The problem was that previous quarterly results suggested that the company’s US subscriber base was reaching a plateau a bit too low.  After a lackluster 3Q with static US subscriber rolls, Netflix found nearly 4 million new streaming customers, with more than half of them in the US.  That’s 13% overall sub growth for the quarter, composed of 8.2% growth domestically and 42% outside the borders.  Apparently, a lot of those tablets and game consoles sold during the Holidays were used to hook with Netflix, just in time for the swath of new original programming coming over the next couple months.  Oh, and the company turned a profit – delivering 13 cents of earnings in a quarter that everyone expected to be a loss.

Of course Netflix has many miles to go on its quixotic quest to unseat the cable network titans and establish itself as the undisputed champion of subscription video.  The success or failure of the original programming – the splashy Kevin Spacey vehicle “House of Cards”, the much anticipated return of the cult hit comedy “Arrested Development”, and a few others – seems to be a make or break point for the company.  This quarter’s subscriber numbers raise the odds on a “make” considerably.

For our full research notes, please visit our published research site.

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