In the second quarter, Netflix, Inc. (NASDAQ:NFLX) added 630,000 new domestic subscribers and 610,000 international subs. The top and bottom lines both improved markedly year over year, with earnings jumping from about a dime a share to nearly $0.50. Taken as a whole, the company turned in a good quarter.
However, the subscriber numbers were less than what Wall Street had been expecting, sending the shares notably lower on the news. The stock has traded down from around $270 a share to about $245. Even at this price, however, investors are pricing in near-perfect outcomes. If they don’t come to pass, there’s notable downside risk.
In the way?
There are some issues to watch at Netflix, Inc. (NASDAQ:NFLX). For example, the company’s mail DVD service has fallen from about 9.25 million members to around 7.5 million. That’s to be expected as customers migrate online. However, that service is wildly important, contributing $109 million in profits. With four times as many subscribers, the streaming service contributes about $150 million.
To make matters worse, the international unit continues to bleed red ink. While it is growing quickly, the company will need to turn a profit overseas sooner rather than later as DVD subscribers continue to fall off. And, like the domestic business, foreign streaming subscribers aren’t likely to be as profitable as DVD subscribers.
Similar but different
Clearly, the company is using its DVD cash cow to push growth in streaming, only streaming isn’t as profitable. That sounds a lot like AOL, Inc. (NYSE:AOL), which isn’t all that flattering a comparison. AOL, Inc. (NYSE:AOL), the one time Internet “walled-garden” leader, has seen revenue decline every year since it split from Time Warner.
The company seems to have stabilized the top line at about $2.2 billion, with around $1.4 billion coming from advertising and the rest largely from legacy subscriptions. However, in 2008 the company’s advertising revenue and subscription revenue were essentially equal at around $2 billion each. Subscription revenue has fallen steadily since that time, keeping the top line in neutral. Look out if that trend starts to show up at Netflix, Inc. (NASDAQ:NFLX).
AOL, Inc. (NYSE:AOL) has gone from an internet service provider with content to an ad supported web publisher. Not too different from Netflix, Inc. (NASDAQ:NFLX) if you consider that it its relying on low-cost subscriptions instead of advertising for revenue. AOL’s forward price to earnings ratio is under 15, Netflix’s forward PE is around 80. With its price still stuck in neutral, AOL may have more upside than Netflix, Inc. (NASDAQ:NFLX) as it navigates a similar business shift because investor expectations are so low.
What goes up…
Investors are an emotional bunch over short periods of time. For a prime example, look no further than Apple Inc. (NASDAQ:AAPL). At one point, it seemed like Apple Inc. (NASDAQ:AAPL) could do no wrong and investors bid the shares up to amazing heights. Fairly quickly, however, Wall Street came to the conclusion that sales wouldn’t grow to the sky and Apple Inc. (NASDAQ:AAPL) fell about 40% in just a few months. That’s the downside risk investors are facing in Netflix.
The funny thing, however, is that Apple Inc. (NASDAQ:AAPL) is now far more appealing. The stock yields around 2.8% and has a forward PE of around 12. It has to deal with saturated mature markets and less compelling new technology, but those risks appear priced in already. Moreover, it is paying shareholders well to wait for it to right the ship.
…must come down
Netflix, Inc. (NASDAQ:NFLX) shares are still being priced for perfection. The business model is good, but there’s still an important transition going on under the covers and within the streaming industry. If anything goes wrong, investors are likely to flee. AOL is facing a similar business shift, but is doing it from a much lower valuation level, which could make it a better alternative for some investors.
That said, Apple Inc. (NASDAQ:AAPL), which is a good option for growth and income types, shows that Netflix could again become a compelling investment — but only if its price falls notably from its perch.
The article This Company’s Virtuous Circle Can Only Grow so Far originally appeared on Fool.com and is written by Reuben Brewer.
Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Apple and Netflix. The Motley Fool owns shares of Apple and Netflix. Reuben is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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