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With a Fantastically Foolish Facebook Update, Netflix Once Again Let Expectations Get Out of Control


History repeats itself as Netflix's Reed Hastings raises expectations too high.

MINYANVILLE ORIGINAL Netflix (NFLX) is partying like it's 2011, with shares trading down an astounding 20% to $64.50 after the company delivered ts second-quarter earnings results.

The quarter wasn't exactly a disaster. The company reported a profit of $0.11 per share, easily beating the consensus estimate of $0.05 per share. Revenue was in line at $889 million, as were subscriber numbers.

However, the company admitted that the back half of 2012 is looking pretty lousy.

Here's the key quote from the company's Investor Letter (all emphasis mine):

For Q3 quarter-to-date, our domestic net additions are very nearly the same as Q3 2010 over the comparable partial period. In that quarter two years ago, we finished with 1.8 million domestic net additions. However, in the middle of that quarter, we launched Netflix on the iPhone to great reception, and we don't have an equivalent launch this quarter. Moreover, this quarter the Olympics are likely to have a negative impact on Netflix viewing and sign-ups. So, our Q3 guidance is 1 million to 1.8 million domestic net adds. If we finish Q3 in the high end of that range, we would remain on track for 7 million domestic net additions for the year; otherwise it would be challenging to achieve that goal by year end. In either case, we are generating impressive growth this year in our most developed market.

Netflix also admitted that competition could start to be a problem:

We have yet to see HuluPlus or Amazon Prime Instant Video gain meaningful traction relative to our viewing hours, but as we continue to build a domestic profit stream they are likely to increase their efforts to gain viewing share.

Plus, international losses are creeping up:

Our highly profitable US business, both streaming and DVD, is funding our international expansion. We believe this is the right long-term approach. In Q3, we expect to be profitable, while with the launch of a fourth international market in Q4, we will move to a consolidated loss.

Note: Going into the quarter, Wall Street was forecasting a $0.03 per share profit for the fourth quarter

However, let's jump in the DeLorean, kick it up to 88 mph, and travel back to the night of July 3, when CEO Reed Hastings made this fantastically foolish Facebook (FB) update:

Note the timing -- July 3 was after the second quarter closed, and by then, Mr. Hastings should have had a pretty darn good idea of exactly how well Netflix was doing.

That announcement sent the stock rocketing up 13% on July 5, the next day of trading.

Here was my reaction on the Buzz & Banter (click here to take a free trial, you won't be sorry!):

Netflix is trading up sharply this morning after CEO Reed Hastings announced on Facebook that Netflix monthly viewing hours crossed the 1-billion hour mark for the first time ever.

Sounds like a piece of important information to just casually put out on Facebook....

Now the tricky question is, will that 1-billion hour metric actually translate into a better-than-expected quarter?

It would be monumentally silly for Hastings to drive up expectations heading into the quarter, given how badly the stock crashed last year after the company failed to hit overly-optimistic guidance.

So assuming Hastings learned his lesson, you'd have to think that there's no way he'd possibly put out that number unless he was absolutely certain the market would like the Q2 results, which hit on Tuesday July 24.

Therefore, it's possible that the stock performs well into the quarter, after which we'll likely see a monster move.

In which direction, who knows?

So yes, Mr. Hastings made an absolutely spectacular error in judgment when he put out that Facebook update, given how many times the stock's been smashed because of expectations that ran too hot.

Why on Earth would he raise people's hopes after he had to know things weren't going so well? Could there have been some massive deterioration in momentum in the past three weeks?

Mr. Hastings is indeed a true visionary.

However, if he is to get Netflix through these trying times, he must learn the dark art of keeping expectations low.

As for what to do with Netflix's stock, frankly, I don't see the point of trying to bottom-fish. It's just too hard a situation to figure out.

The aforementioned Amazon (AMZN) and HuluPlus, as well as Apple (AAPL), are very likely to put serious competitive pressure on Netflix in the future. I don't yet see any one of them knocking Netflix off the top of the video heap, but add them together Voltron-style, and as a whole, they can cause problems.

The best way out for the longs may be an acquisition. Incidentally, Mr. Hastings is on the boards of two possible buyers -- Facebook and Microsoft (MSFT), both of which have money to burn on deals and the demonstrated willingness to do so.

But then again, when I look back in my account statements at how much dough I've made betting on acquisitions, I'm looking at a big fat goose egg.

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