Quick Thoughts: NFLX – One Strike is Not an Out

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–          NFLX disappointed investors on sub growth, missing guidance for 3.7M new subs by 19% as a price hike and a relatively weak slate of new programming releases dampened demand

–          The disappointing results were amplified by TWX’s announcement that it would offer HBO as a stand-alone streaming service in 2015 – we expect a significantly higher price point than NFLX

–          While sales disappointed vs. consensus, they were up 89% YoY, an acceleration from 2Q14’s 85% growth, a better indicator of imperfect forecasting than real operating problems

–          We remain confident in NFLX’s long term trajectory and expect substantial further sub growth going forward. We also see significant opportunity for advertising revenues down the line.

This is why many technology CEOs hate to give guidance. After blowing out numbers for the past three quarters, NFLX honcho Reed Hastings offered a 3Q14 target of 3.7M new subscribers, a projection of 33.4% YoY growth in total subs and a slight acceleration against the 33.3% growth the company delivered in 2Q. OOOPS! NFLX only delivered 3.0M new subs in the quarter, missing the total sub number by 1.3%, and BOOM! NFLX stock is down 25% as I write this.

It turns out that when you raise prices by 12.5% on a mass market consumer good, it has a negative impact on demand volume. Who knew? Perhaps Hastings had grown confident in the warm glow of Emmy nominations for NFLX’s “Orange is the New Black” and “House of Cards”, both of which had launched new seasons in the spring amidst fanfare and drove strong sub numbers in the first half of the year. Unfortunately, there were no such publicity-magnet tent-pole shows arriving during 3Q and the impact was apparent in the sub numbers. Still, 33.3% YoY growth in subs and nearly 89% growth in revenues should not be taken as some sort of indicator of doom.

Perhaps investors juxtaposed the missed forecast with TWX’s earlier announcement that it would launch a streaming version of its HBO cable channel without requiring a subscription to PayTV. I can see this argument both ways – there will be some households that will choose the new HBO service over NFLX, but there will be others that will be emboldened to cord cut or cord shave and will take both. However, given that TWX’s HBO on-line launch is likely a year away and that it will also likely carry a price point significantly higher than NFLX’s $8.99/month, I believe that it will validate NFLX’s value for consumers. NFLX has yet to reach HBO’s heights in delivering must-see programming, but it has a good start and should continue to get better.

NFLX also has further opportunities to exploit its deep learning on the viewing preferences of its subscribers. The company’s big data analyses clearly inform its decisions to acquire programming and give it a substantial advantage over traditional media buyers, but it could also use that knowledge to drive advertising. Hastings has been adamant over the years that NFLX would not offer an advertising driven service, but then again, he also tried to split off his DVD rental business after he said he wouldn’t and then changed his mind and kept it in house. Obviously, there is a reasonable chance that he will change his mind, and the opportunity is substantial.

Given all of this, I am inclined to see the 3Q miss as a hiccup. NFLX’s strategy is working, it has substantial operating advantages against its would-be competitors, and those competitors are very late to respond. As the price increase is metabolized by consumers and as new programming launches and critical acclaim continue to raise the company’s profile, I expect to see NFLX beat a few quarters against expectations tempered by this atypical misstep. A 25% drop is an overreaction and a considerable buying opportunity for a company uniquely well positioned for the future of video.

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

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