The Company

The News

Investors gave lousy reviews to

Netflix

The Los Gatos, Calif., company late Monday reported earnings of 21 cents a share for the first quarter, in line with Wall Street estimates, though four cents came from sales of short-term investments, cutting the operational profit to 17 cents a share. Netflix earned 14 cents a share in the year-ago quarter.

But gross margins sank to 31.7%, a drop of 450 basis points from the year-ago quarter and 210 basis points from the previous quarter, based mostly on the company's growing expenditures on streaming video technology. Streaming video lets customers watch movies directly off the Internet, rather than on DVDs delivered by mail.

That prompted Netflix to pull back on full-year guidance, with a new range of 2008 earnings between $1.16 and $1.29 a share, down from earlier estimates of $1.18 to $1.30.

Netflix closed the first quarter with approximately 8.2 million total subscribers, a 21% rise from the year-ago quarter. Its churn rate, the percentage of subscribers lost, dropped to an all-time low 3.9%.

"The big challenge for us remains the same as it was when we first launched our Internet delivery initiative, to satisfy ourselves and our shareholders that our online content spending will result in increased subscribers and profits," Chief Executive Reed Hastings said on a Monday conference call.

Soleil Securities analyst Daniel Ernst on Friday dropped his rating on the stock to Hold from Buy, based on the cost of the streaming technology investments.

The Analysis

For a company started from a simple, appealing idea DVDs rented online, and shipped and returned through the mail Netflix now has enough moving parts to be a fairly complicated story.

The first wrinkle is that its guidance is actually worse than it seems at first glance, because the company plans to take tax credits worth 9 cents a share in the current quarter, which Hastings said "wasn't originally contemplated in guidance."

Pali Research analyst Stacy Widlitz wrote in a Tuesday note that the investment sales and tax benefit have enough impact on earnings that it "may be a reality check" for the investors who sent shares soaring 53% for the year to date through last Thursday, when shares reached a 52-week peak of $40.90.

"Therefore, taking both one-time events into account, the actual guidance appears to be a range of $1.03 to $1.16 for the year," she wrote, and its midpoint of $1.10 a share would only represent year-over-year earnings growth of 13%.

Ernst, of Soleil Securities, says that when investors consider the margin pressures from increased technology spending, "that's not a good thing."

"They suggested those margins would stay there for the next two quarters and have some improvement in the last quarter," he says. "Most of that hit came from digital."

There's also the rising popularity of high-definition Blu-ray DVDs, which are more expensive for Netflix to buy and will probably require a price increase for customers to consider.

All of this is occurring as prime competitor Blockbuster is in the midst of a takeover attempt of electronics retailer Circuit City, which, if successful, would largely cede the online rental field to Netflix.

"While management provided no commentary on the BBI/CC proposed deal, we continue to believe that if successful, it would be positive for NFLX and may ultimately push BBI to exit its DVD-by-mail business by selling to... NFLX," Jefferies & Co. analyst Youssef Squali wrote Tuesday.

The second half of the year will also see the arrival of devices that will let rented streaming video play over regular television sets. Netflix is already working with LG Electronics, the Korean manufacturer, and announced three new partnerships on the conference call.

The Bottom Line

The spate of moving parts in a constantly shifting technological arena adds up to short-term scowls but longer term optimism from Lloyd Walmsley, an analyst with Thomas Weisel Partners.

"We cut our EPS numbers and expect frustrated investors could lead the shares to a time-out period," he wrote. "Despite our own frustration, we think Netflix shares present a good investment as the company's strategic position looks stronger going forward even if the potential for earnings upside in the near-term appears somewhat less likely than we had previously imagined."

Widlitz also pointed out that "there are a number of large, well-capitalized companies competing in the digital video delivery space," including Apple, Microsoft, Amazon.com and Sony.

"We have said for a long time that we believe that if we were handicapping, we believe AAPL will eventually win out and we continue to believe so," she wrote.

But his year has already marked a turning point for Netflix, whose stock has been volatile even as the company remains beloved. Blockbuster seems to be turning away, Widlitz wrote, and that's dropped its subscriber acquisition costs and ramped up its customer ranks.

But as the credits roll, investors should ponder whether 13% annual earnings growth can justify the valuation of this stock, even after Tuesday's two-thumbs down treatment from the market.