The fall of Netflix ( NFLX) stunned investors Friday, as the debate about the mail-order DVD rental firm's prospects only got louder.Netflix shares slid 26% in the wake of Thursday's
Value JudgmentThe debate over Netflix, a heavily shorted stock, touches on several themes recognizable to investors -- particularly those who have sought to value fast-growing media companies carving out new businesses. As with satellite radio companies XM ( XMSR) and Sirius ( SIRI), some key issues are how quickly a company can acquire new customers, how much it will cost to do it, how long those customers will stick around, and how much a company will have to spend to keep them happy. For Netflix bears, Thursday's earnings release and conference call with analysts gave them additional morsels to feast on. While subscriber acquisition costs for the second quarter came in in line with expectations, the company said Thursday that its SAC budget would increase from about $35 per subscriber to between $37 and $39. The company says it will advertise more on television in the third quarter, and is cutting back on online advertising because of second-quarter rate increases.
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The Netflix rally
Customer ConcernsFor Mahabir, the issue of higher subscriber acquisition costs comes on the heels of two other concerns that came to the forefront in this spring's first-quarter earnings results. One of those is growth in acquisition costs for the DVDs in Netflix's inventory; the other is the growth in usage, or the number of movies that paying customers rent each quarter. Netflix customers pay a flat monthly fee for DVD rental, enabling them to hold up to three titles at a time, but giving them the opportunity to return those titles and receive new ones on an unlimited basis. Short-sellers have argued that the business model makes Netflix most attractive to its least-lucrative customers -- people who take advantage of the exchange privilege to watch as many movies per month as possible. Netflix reported 6.7 DVDs per subscriber per month in first quarter and 6.6 in the second quarter. Mahabir says the company in previous quarters didn't disclose specific usage numbers but indicated they were below six, suggesting that the number spiked in the first quarter.
Growing PainsEven analysts with a positive rating on Netflix found reasons to lower their expectations for the company. Citigroup Smith Barney analyst Lanny Baker wrote that the second-quarter results and the company's outlook "contained more signs of growing pain than we expected." Baker, who has a buy rating on the stock, lowered his price target from $42 to $36.
Following the company's second-quarter move to raise its monthly subscription rate from $19.95 to $21.95, Baker says it appears that Netflix's churn rate -- the percentage of subscribers who drop the service -- will be slightly higher than expected over the next six months. Summing up his report, Baker writes, "We believe our sub-growth-plus-price-hike-equals-margin-expansion investment thesis remains valid, though the timing is pushed out slightly and the trajectory is lowered some as well." According to the latest figures from Nasdaq Trader, 20.2 million Netflix shares have been sold short by investors betting the price will fall. That amounts to 31% of the company's 65 million fully-diluted outstanding shares. After subtracting out the 20.4 million held by Netflix's officers and directors, as of March 4, the short interest amounts to 45% of the company's estimated float. While Netflix swooned, shares in its big competitors held steady. Blockbuster slipped 14 cents to $14.43, Movie Gallery ( MOVI) added 2 cents to $17.74, and Hollywood Entertainment ( HLYW) added 3 cents to $13.11.