Netflix Guidance: Why It's Even More Shocking Than It Seems

By Michael Comeau  JUL 26, 2011 9:15 AM

Hope has become way too big a part of the equation in any bullish argument for Netflix stock -- and that's scary.

 


If you own Netflix (NFLX), then you’re in the house of pain this morning.

The revolutionary movie-rental service hit its first stumble in recent memory yesterday after dropping a disappointing second-quarter earnings report, complete with lackluster Q3 guidance.

The stock is getting wrecked, and valuation-obsessed bears are finally smiling after spending the past two years watching Neftlix hit all-time highs just about every day.

However, there’s a big story here that the media is completely ignoring: Netflix’ bizarrely optimistic fourth-quarter expectations, which indicate that management is both out of touch and overconfident.

Before we get into that mess, let’s take a quick look at the headline numbers:

Heading into the quarter, Netflix was trading at 62 times expected full-year earnings, so needless to say, it was more or less priced for perfection.

Therefore, the beating that Netflix is receiving today should come as a surprise to no one. That’s just the nature of expensive momentum stocks: When they crash, they crash hard.

But what’s really shocking is that Netflix is setting itself up to take a second -- and possibly bigger -- hit three months from now when third-quarter earnings are released.

Let’s break it down.

On July 12, Netflix announced it was separating its physical DVD-delivery and online-streaming distribution services, effectively raising its prices by as much as 60% for some customers.

I goofed and thought that the price hike wouldn’t be that big a deal (see IBM: King of the Old-School Tech Giants).

That was completely and utterly wrong, as indicated by this statement from Netflix:

In Q3 we will see only the negative impact of the pricing change, given that the announcement was early in the quarter and that the increases won’t take effect until late in the quarter (September 15 on average).

We expect domestic net additions in Q3 to be lower than the previous year Q3, and because of the timing of the price change, revenues will only grow slightly on a sequential basis.

This makes sense. Netflix is expecting a near-term hit in demand and is appropriately lowering expectations.

But here’s where things get bizarre.

Immediately afterward, Netflix said this about the fourth quarter:

In Q4, we expect domestic net additions to return to a pattern of year-over-year growth while revenue will reflect a full quarter’s impact of the pricing changes, which could result in Q4 being our first billion dollar global revenue quarter, driven by strong U.S. performance.

Common sense says that Netflix wouldn’t mention the possibility of hitting $1 billion in revenue in Q4 unless it had some reasonable expectation of hitting that mark.

So Netflix expects nothing less than business as usual in Q4, despite a serious disruption in momentum during Q3. That smells like overconfidence and a lack of humility to me.

As of 4:00 p.m. on Monday, Wall Street was looking for Netflix to generate just $923 million in revenue for Q4, according to Reuters.

So by bringing up this $1 billion number, Netflix blasted away a whole lot of valuable wiggle room.

It would be much better to ultimately report revenue at $900 or $925 million without having brought up this $1 billion number at all. One quarter from now, any Q4 guidance issued below $1 billion will be viewed as a guidance cut -- and another reason to dump the stock.

I mean, what if growth doesn’t just magically bounce back? What if Amazon (AMZN) and Apple (AAPL) turn up the heat with promo deals on their video-streaming services? What if the movie companies start demanding even bigger bucks for film rights?

Here and now, Netflix is looking a lot more like a short than a long.

Hope has become way too big a part of the equation in any bullish argument for the stock -- and that’s scary.

Position in AAPL

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