The Challenges That Lie Ahead For Netflix

Investors have continued to punish Netflix (NSDQ: NFLX) for failing to meet expectations with yesterday’s disappointing Q3 earnings report, sending the stock down nearly 35 percent by early afternoon as the video renter lost more subscribers than expected during the period. That obscured some otherwise stellar performance numbers: a 42 percent increase in total subscribers to its video rental services year-over-year, posted 63 percent higher profits and a 49 percent revenue gain — all of which suggests that Netflix should be able to ride out the storm, though it will take a while until it’s out of the woods.

Netflix’s troubles began in July when it said that it would split its DVD and streaming video businesses into two separate subscription services — and charge consumers 60 percent more per month if they wanted continued to access both. Over 800,000 Netflix customers fled when the change went into affect in September, as the company admitted in its Q3 earnings.

While the profit and revenue growth would certainly have been greeted with unanimous cheers at just about any other company, all public companies ultimately have to compete against expectations. Netflix compounded consumers’ ire over the pricing change by the proposed rebranding of the DVD business as Qwikster and then by abandoning that plan less than a month later.

It’s easy to dismiss all this as an anomalous stumble from a company that was tripped up — and now chastened — by hubris after flying so high, so swiftly. But the incidents expose clear vulnerabilities in Netflix’s value, which is why investors have appeared to ignore otherwise solid performance and the dominance over other video services with its 24 million remaining subscribers.

As CEO Reed Hastings told investors, the path towards profitability in Canada is clear, but expenses for its global rollout are will lead to losses in 2012. Therefore, after its Q1 launches in Ireland and the UK, Netflix will halt its international expansion.

That will stall any major reversal of the company’s fortunes in investors eyes. And Netflix will probably have a tough time winning back consumers’ hearts and minds without any significant discount or marketing campaign in the face of increasing competition. As Hastings said during Netflix’s earnings call, there will be no “grand gestures” or any notable price reduction.

In Netflix’s mind, consumers were essentially getting two free services for the cost of one; when it decided it needed to charge to cover the heavy broadband bills and expenses related to content licensing, the revolt was expectedly sudden. The company feels that over time, as it transitions to a streaming-only business, consumers will forgive and forget. But Hastings also noted that he sees the DVD rental business winding down over a long period of time, until a point when the streaming side can fully support the company’s financial needs. That long farewell to DVDs will give other video providers an opening.

Still, most investors have some hope for Netflix being able to maintain its hegemony. As Citgroup analyst Mark Mahaney said in a research note, answering his own question of why the bank doesn’t advise selling, video is a “hyper-growing” market and Netflix still has a big headstart on the competition. It probably has learned something from this experience and it does move quickly when it takes a wrong turn.

Given all that, Netflix will probably be able to hold on to its customer base as it continues to work assiduously on striking new content agreements. But the soaring rise that characterized Netflix’s performance up until September will not be something it can return to. That chapter has ended and Netflix is on to a completely new story now.