As Netflix (NASDAQ:NFLX) steps into the financial spotlight to announce its fourth-quarter earnings Wednesday afternoon, you can’t help but sense the growing interest in the report, as if everyone is half-expecting to see the beginning of the end of Netflix’s longtime rally.
Netflix is considered to be overpriced by many. It sports a price-to-earnings ratio of 70 based on 2010 earnings and 48 based on 2011. But that’s nothing new. Like Amazon (NASDAQ:AMZN), Netflix is one of those stocks that investors grant a perennially high valuation.
For their optimism, investors have been amply rewarded with steady price gains — Netflix’ stock has steadily risen from $36.88 two years ago to about $184 now. Well, not for the entire two-year period — on Nov. 30, Netflix peaked at an all-time high of $205.90 and has treaded sideways ever since.
What changed? There seemed to be a growing sense that Netflix was running into some pretty large obstacles even as it’s emerging as the premier service for streaming movies and TV shows. The concerns were distilled into an articulate summary by a value fund manager in mid-December: Netflix’s subscriber growth will begin to slow; licenses for online videos were adding to inventory costs; and cash flows were at risk.
Netflix CEO Reed Hastings made an equally articulate defense of the company. But in some ways it only called attention to the concerns, as if validating them by arguing them down. And now that the company is getting ready to discuss its latest quarter, others are weighing in with bearish outlooks.
First, Michael Pachter, analyst with Wedbush Morgan Securities, said in a note that the costs for Netflix to build a robust streaming library would be a drag on margins “for at least another year.”
Subscriptions are still growing — analysts expect that Netflix added 7.4 million last year, bringing the total to 19.7 million by 2010’s end — but that’s not enough. Mark Mahaney of Citigroup suggested Wall Street won’t be happy unless Netflix says it expects to add another 8.5 million of them in 2011.
On Monday, Caris & Co. analyst David Miller raised another concern: Netflix has been pushing so hard for people to give up their DVD-by-mail subscriptions (which involve higher distribution costs than video streamed over servers) that fourth-quarter revenue could take a hit as people shift from $9.99-a-month DVD plans to $7.99-a-month streaming-only plans.
Piecing it all together, you start to see a scenario where Netflix keeps pushing to become the go-to site for online movies and TV episodes. While that’s resonating strongly with consumers, it could take a tough toll on Netflix’ financial performance over the next year or so — as revenue growth slows while licensing fees grow. And beyond that, Netflix could start to see its market saturated in the U.S.
Of course, the bearish mood can end up serving Netflix bulls if they prove to be overblown. A stronger-than-expected report could propel Netflix higher. But a disappointing quarter could draw back in the short-sellers, who were fond of betting against Netflix for years, before throwing in the towel last spring.
To gauge the outcome either way, Netflix’s earnings will be watched closely for signs of how things could shake out. The company has strong leadership, and a lengthy track record of defying the doubters. Yet it’s clearly facing financial pressures as it pushes to expand its reach. Can Netflix continue to keep firing on all those cylinders? We should have a better idea on Wednesday.
