Netflix Screwed Up, But Wall Street's Reaction Is Just Nuts

The company's stock is down 74% in just three months. Has that much really changed between then and now? 

No company is perfect. Firms are run by people, and people make mistakes. As Netflix has found out over the past three months, some mistakes are bigger than others. After announcing its price hike in July, its stock has plummeted 74%. Does what we now know about the company really justify its stock price falling from almost $300 to near $75 this morning?

The Infamous Price Hike

For those who haven't been following along, the trouble started when Netflix announced that it was hiking its prices by as much as 60%. While incremental price increases were unavoidable for the company's continued growth, raising prices by so much so suddenly was a bonehead move. Subscribers flipped. In response, some cancelled the service and some downgraded their service to cheaper plans.

If you know anything about economics, then you know that this result was utterly predictable. When consumers face higher fees for a service, some will be priced out of the market.

But here's the thing: not that many customers actually left. During the third quarter, the company lost 420,000 paying subscribers. That's about a 2% decline. Meanwhile, fees increased by as much as 60%. Is the company really worse off?

Not if you look at revenue: despite fewer subscribers, Netflix's revenue rose by $33 million or 4% compared to the second quarter. Year-over-year revenue is up 49%.

Its net income did decline quarter-over-quarter, however. But that's because its subscription expenses rose -- not because of its revenues. Netflix continues to invest in its streaming business, which investors should see as a positive. As its library of titles gets more robust, subscribers will be more interested in the streaming service and will be more willing to pay Netflix's higher price. Oh, and year-over-year net income was up 65%.

Troubling Q4 Guidance

But investors care about the future, not the present. And Netflix revealed some additional troubling information about the fourth quarter. It expects domestic subscriptions to decline between 7% and 14% this quarter. That's bad, but the company also believes that its pain has already peaked. It says subscription declines will diminish in future quarters.

Also, almost its entire decline in subscriptions is expected to come from Netflix's DVD-by-mail service. Since Netflix knows that streaming is the future, DVD-by-mail subscribers leaving shouldn't trouble us as much as if streaming subscribers were fleeing the service.

Netflix further expect its revenue to be approximately flat to up 4% this quarter -- so this decline in its subscribers should be pretty easily absorbed by the company, thanks to its price hike. But it does expect its global profit to decline as well, by as much as 70%. In Q1, income will go briefly negative. But these weak profits are obviously not due to declining revenues -- they're due to more investment and the company's international expansion.

The Qwikster Debacle

In response to company outrage, Netflix announced in September that it would separate its streaming and DVD-by-mail business, calling the latter "Qwikster." But less than a month later, the company changed its mind: Netflix would remain a single company.

This episode might make investors question whether Netflix's management has any clue what it's doing. Is the wondrous Netflix story they believed earlier this year broken? Maybe, but it's also a relatively young company. Management makes mistakes. The Qwikster nonsense looks like a hasty, poorly thought out reaction to investors freaking out over the company's subscriber decline. You could even argue that the company deserves some credit for realizing that its idea of splitting up the company wasn't a good one, so it quickly reversed course.

Netflix's Potential Remains the Same

Few have been more critical of Netflix's recent behavior than I have. I worried that its price hike could lead to a big subscriber drop and lower revenues. We haven't seen either and probably won't. I also feared that the initial Qwikster decision lacked foresight, but the company quickly reversed it. Netflix is actually faring fairly well, under the circumstances. Yet here's Wall Street's reaction:

Really, the company has not experienced any fundamental change between July and September, when its stock fell from about $300 to near $75. Before that, investors knew that streaming was the future. They also knew that it was an expensive undertaking. Netflix has proven both points: its streaming subscribers have outgrown its DVD-by-mail subscribers and appear to be more willing to stick around. Meanwhile, the current and coming profit declines are due mostly to the expense associated with the company's streaming expansion and global growth.

Netflix still appears poised to be the leader of streaming content in coming years. Its DVD-by-mail business is still profitable. Its revenues continue to rise. Even if its stock was overvalued at its July peak, a 74% drop in a little over three months is enormous. Was it really that overvalued? The company may now be undervalued: investors may be overreacting.

Update: For some fun perspective, Rebecca Rosen of our Tech channel compares the effect on the stock price of two companies' recent mistakes: Netflix and BP. Check it out!