Skip to main content

The fall of Netflix (NFLX) - Get Netflix, Inc. Report 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

mixed second-quarter earnings report. While revenue rose 90% from a year ago, per-share profits fell short of Wall Street estimates. Grabbing the most attention was the company's prediction that it would spend more in coming quarters to expand its subscriber list.

Friday's Netflix selloff highlights the vigorous tug-of-war between the company's rabid fans and its voluble detractors. Even as Netflix lost a quarter of its value in heavy trading Friday, the stock still had risen fivefold in the space of two years. And while some people warned of growing competition from deep-pocketed giants like


(BBI) - Get Brickell Biotech, Inc. Report

, others predicted nimble Netflix would run circles around slower-footed rivals.

Netflix shares dropped $8.25 to $23.75 Friday.

Value Judgment

The 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





(SIRI) - Get Sirius XM Holdings, Inc. Report

, 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.

Scroll to Continue

TheStreet Recommends

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.

Giving Some Back
The Netflix rally

As analyst Alden Mahabir of Janney Montgomery Scott's Vintage Research pointed out in a Friday note, the new guidance contradicts the company's indications, made less than five months ago, that SAC wouldn't increase for the next few years -- a forecast that Mahabir says he didn't put much faith in back then.

"At the time," Mahabir wrote this Friday, "it only seemed logical to us that the company would need to spend more as competition increased (i.e., Blockbuster)." Mahabir has a sell rating on Netflix and a price target of $26.

Customer Concerns

For 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 Pains

Even 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


added 2 cents to $17.74, and

Hollywood Entertainment


added 3 cents to $13.11.