Netflix Q1: Tanking On Guidance (NFLX)

As expected, Netflix had a solid winter. But the stock is getting hammered in after-hours trading -- down 13%.

Why the drop? While Netflix increased its subscriber and revenue guidance for full-year 2008, the company left its full-year net income forecast alone. And its EPS guidance, which it trimmed to $1.16-1.29 for the year, is below analysts' $1.25 consensus.

Why? One explanation offered by Netflix CFO Barry McCarthy: Analysts are understimating how much Netflix is spending on its Internet streaming service, specifically on content rights. He didn't, however, say how much they're paying for rights, or shed any light on future costs. So this could come back to bite Netflix a couple more times.

For Q1, Netflix mostly met its numbers, but didn't beat them -- which many analysts were expecting. The company reported $326.2 million of Q1 sales, up 7% year-over-year, but short of analysts' $326.9 million consensus. EPS came in at 21 cents per share, in-line with analysts' estimates. And the company added 764,000 net subscribers during the quarter, finishing Q1 with 8.24 million subs, at the high end of their guidance but short of Jefferies' bullish 8.25 million estimate.

Gross margin also dropped to 31.7%, down from 36.1% in Q1 2007 and 33.8% in Q4 2007. CFO McCarthy blamed the gross margin decline on a seasonal increase in disc usage, resulting in higher postage, packaging, and fulfillment expense.

Also troubling: Netflix expects growth to slow rapidly this quarter. It expects to finish the June quarter with 8.3 million to 8.5 million subscribers -- meaning it only expects to sign up 60,000 to 260,000 net subscribers in Q2. Jefferies, for comparison, had estimated that Netflix would add 344,000 net subscribers during Q2.

In Q2, Netflix expects sales between $334-339 million (midpoint of $336.5 million is above $335 million consensus) and EPS of 33 cents to 43 cents (midpoint of 38 cents is below 39 cents consensus). More in the release.

See Also: Netflix: We'll Charge Extra For Blu-ray Rentals

Earlier: Netflix Q1 Earnings Preview: Living Up To The Hype?

LIVE conference call notes:

5:01 Call begins.

5:02 Reed Hastings joins. Expect 9.4 million subs by year-end (midpoint if guidance). EPS growth: $1.23 midpoint (below consensus!) but up 27% from 2007. In Q1 subscriber net adds up, SAC less than $30. Churn at 3.9%. All three record performances.

5:03 Late December Blockbuster flaked off. Some of benefit will be long-lasting, some will be a one-time benefit. While Q1 was all-time record in net additions, don't expect Q2 to be a record Q2, or 2008 ro be a record full year. Also spending less money on marketing than did in 2006.

5:05 Fine with lower growth in Q2 because they're letting us fund instant-watch efforts. Over the coming years, Blu-ray DVD players will fall in price and become more widespread. DVD market more likely than ever to remain enormous for many years. As you are aware, purchasing Blu-ray discs costs more. Consumers are used to paying more for HD in every other channel. Because of higher cost of Blu-ray and consumer expectations, planning on implenting a modest monthly premium for access to Blu-ray sometime this year. Today, percentage of subs who rent Blu-ray in low single digits, but sure to grow.

5:06 More than 9,000 movies and TV episodes available. Instant-watch only on Windows PCs. Fine for laptops, technophiles. More attractive to consumer electronics partners. Want integrated into Blu-ray players, game consoles, TVs, standalone devices. In January, we talked about LG. We have LG plus three additional partners actively working on integrating our technology. Three of four partners are major companies which each sell millions of devices this year, which will hit in Q4. Fourth is a small company which will launch sooner than Q4.

5:08 Rumors about who we partnered with. (Microsoft, for example.) Will announce in coming quarters. Nothing will be material for financial results for forseeable future.

5:12 Turning call over to CFO McCarthy. Price cut was investment in faster growth. Expecting to continue. (Really?) First time in more than a year a y/y acceleration in sub. growth.

5:13 Gross margin 31.7% declined 210 bps sequentially. All caused by seasonal increase in disc usage; higher postage, packaging and fulfillment expense. Expansion in margin related to declining content costs.

5:14 Expect lower marketing expense on y/y basis for remainder of year, faster subscriber growth. Why aren't you spending more money on marketing to grow faster? We are -- quite a bit more. Last July, we said two ways to invest in faster growth. We chose price cuts. Judging from accelerated growth past two quarters, seems to be going well.

5:16 FCF better than expected by several million. Saw seasonal decline caused by decrease of cash from ops as gift subscriptions slowed. Also bought 80,000 square feet of office space in Los Gatos.

5:17 We expect much of sub growth in Q1 and Q4, reflecting historical pattern of seasonal growth. Expect Q2 to be slowest. Revenue growth will continue to lag subscriber growth because of price reduction. But we expect both sub. growth and revenue growth to accelerate every quarter, with lots of growth after Q3 after price cut comps wear off.

5:21 Q&A begins

5:22 Would you buy Blockbuster's online subs? What else is keeping down full year EPS forecast? How much related to higher than expected digital spending? Barry: Model from operating perspective actually performing well. EPS on trajectory less than projecting probably related to spending how much we're actually doing compared to forecast for streaming capabilities. Primarily the spending on content side. Enormously pleased with the progress we're making there. Hastings: If Blockbuster wanted to get rid of subs, we could probably work something out. I anticipate them to stay in the business for foreseeable future.

5:25 "Technical difficulties." Sounds like a paint mixer! Asking for questions to be emailed. (Note: Why does every conference call inevitably get screwed up? Shouldn't they have this worked out by now?)

5:27 Emailed question: Where's growth coming from? Certainly Hollywood Video's store closures helps. But otherwise no big difference.

5:28 No material change in advertising climate.

5:28 Can you quantify online spend? Online content: Accounted for in cost of revenue line.

5:28 What kind of devices will partners integrate with? See largest opportunity in multi-function devices, like Internet-connected game consoles, Blu-ray players, standalone, TVs. Will be a mix over time.

5:31 Model is more profitable than expecting to be, that enables us to increase growth and maintain profitability. Also seeing better yield on advertising than we're doing. More organic growth, all of which allows more growth without profitability problems. Not getting lower ad CPMs, but more effective with better competitive client and increasing brand awareness and reputation.

5:33 Kiosks a net benefit to NFLX: Speed up store closures and don't steal many mail-order subs.

5:34 Watch instantly: Incremental vs. replacement? Can't tell at this point ... the types of consumers. Different types of users. No clean, control group. Optimistic over time that there will be a substitution effect. Too early to tell on BBI-CC.

5:34 ARPU down quite a bit: I think sequentially, not so much. You may recall there were ad revs before, both lines of business pared back. They make ARPU drop more dramatic than if you just look at subscription business. No structural changes in mix of price point per subscriber.

5:36 Usage is down because of plan mix towards lower price points and lower caps and aging of subscriber base. Content cost in aggregate has increased over what they have been, say, 3 years ago, because of investment we're making in rights for Internet delivery.

5:38 Percent of customers using instant watch? Target titles for year-end? Anything seasonal about R&D spending? Overall, R&D expected pretty steady. Do annual salary revews at end of Q4. Very pleased with adoption of instant watching, chosen to not give out specific metrics. Similarly with target titles. Up to 9,000, up from 2,000-3,000 when we launched, so continue to grow. Pretty disciplined about R&D spending.

5:43 No, our spending plan on digital is about what we thought it would br three months ago.

5:43 Any change in competitive landscape? Minimal marketing from Blockbuster in last few months.

5:44 Option spending involved in the EPS drop.

5:45 Any change in metrics from share gain subs? Any better or worse ARPU, margin, churn trends? Reed: No, no difference in character of new subs over Q1 than in prior quarters. What is best use of cash after you burn through $150 million remaining? More buybacks.

5:46 Landscape on digital content rights acquisition? Any changes on new pay TV plans? Talk about how you structure deals in terms of fixed costs vs. variable costs driven by usage? Obviously a lot changing in terms of specific new initiative. Too early to tell what impact of that will be. We contract for content; sometimes it's fixed, sometimes pay-per-view, sometimes mixed models. Flexible when it comes to that; just want a good deal.

5:47 Watch instantly customers: Any difference in churn rate among those using it? What kind of penetration getting from service? Reed: Really excited by usage, you don't keep using something unless satisfied with it. But this is different subscriber base than other subscribers. Usage has really impressed us. Many more people willing to watch a lot more content than we thought on PCs. No control group, can't give you size of that gap.