Netflix Naysayers: Downside Ahead

Netflix reports another strong quarter, but its momentum may be waning.
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NEW YORK (

TheStreet

) --

Netflix

(NFLX) - Get Report

has been the golden child of the movie sector, but the DVD-by-mail creator could face some tough reviews ahead.

While the company reported yet another quarter of record subscriber growth and earnings that surpassed estimates and upped its full-year outlook, soft revenue sent shares tumbling 11.4% to $106.01 in morning trading.

Netflix also upped its full-year earnings, revenue and subscriber guidance. The company now expects to earn $2.58 to $2.86 a share, from its previous estimate of $2.41 to $2.63 a share. Management anticipates revenue in the range of $2.14 billion to $2.16 billion, up from $2.11 billion to $2.16 billion, and said it will end the year with 17.7 million to 18.5 million subscribers.

The company reported second-quarter earnings of $43.5 million, or 80 cents a share, a 34% surge from a profit of $32.4 million, or 54 cents, in the year prior. This is significantly higher than analysts' estimates of 70 cents.

Netflix ended the quarter with 15 million subscribers, representing a 42% gain from a year ago.

Despite the strong results and indications that momentum is on its side, results were overshadowed by weak sales of $519.8 million, which were shy of Wall Street's forecast of $524 million.

Netflix also noted that it has diminishing top-line visibility the further out it looks, even though it remains confident in its outlook.

There are two competing issues at hand: new subscribers appear to be signing up for the cheaper $8.99 subscription plan to gain access to streaming content, which has contributed to a decline in sales. Netflix's average monthly subscriber bill last quarter was $12.29, down a dollar from $13.29 a year ago.

At the same time, more subscribers are choosing to stream videos rather than order DVDs by mail, which is helping boost margins.

Gross margin reached 48.9% during the quarter, from 45% in the year prior. But Netflix plans on increasing its spending on content, which will limit future increases in gross margins.

It's outlook is also suspicious. "Netflix management expects the company to add as many as 3.5 million subscribers over the next six months, but expects to earn approximately the same net income each of the next two quarters as the company earned in the second-quarter," Wedbush analyst Michael Pachter wrote in a note. "We accept that the company intends to spend a considerably larger amount on content and marketing than it did in the first half of the year, but believe that investors should begin to focus on the lack of leverage in Netflix's business model in order to appreciate our view that the company's shares are overvalued."

While Netflix is expanding its channels of distribution -- beginning to stream movies through

Nintendo's

Wii, creating applications for

Apple

(AAPL) - Get Report

devices, and moving into Canada in the fall -- so are its competitors.

Coinstar's

(CSTR) - Get Report

Redbox kiosks continue to attract users with their $1 rental offerings. Reports also surfaced earlier in the week that Coinstar is planning on venturing into the streaming market.

Bloomberg reported that Coinstar is looking to narrow the gap between the number of titles it offers (currently about 200) and Netflix's selection, which includes more than 100,000 titles by mail and 24,000 streaming movies and television shows.

Hulu

also announced last month that it will launch a paid subscription service to give users access to select current and past TV shows in high definition, including popular series like

Glee

,

The Office

and

30 Rock

. While this launch wasn't unexpected, it is the first new significant competition for Netflix.

The potential increase in postage and potential elimination of Saturday mail delivery also pose threats to Netflix.

Netflix repurchased 400,000 shares, which could impair earnings if revenue falls and content cost rise, Janney Capital Markets analyst Tony Wible wrote in a note. "

This is a scenario we see unfolding as media fragmentation accelerates and competitive pressures exacerbate."

"The major downside to the story is that Netflix is churning through its addressible market of households at an accelerating rate," Needham analyst Charles Wolf wrote in a note. In order to reach 15 million subscribers install base, for example, Netflix has had to sign up over 28 million subscribers. Wolf estimates that the installed base of subscribers could reach 27 million by the fourth quarter of 2011. By then, Netflix will have churned through 48 million households, over two-thirds of its entire addressable market.

The only real new subscriber additions once its potential household base is saturated will come from new video game console purchases. "We believe Netflix will be challenged to grow its current pace for more than another year," Pachter wrote, "and we expect its premium valuation to collapse."

With its stock more than doubling over the past year, it seems unlikely has much more upswing left.

Netflix Stock Rating Report (NFLX) Rating and Financial Analysis

-Reported by Jeanine Poggi in New York.

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