Netflix Sees Sub Growth Doldrums Ahead

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Netflix added about 2 million net new subscribers in the second quarter -- but the movie-rental company expects the pace to fall off significantly in the current quarter following its major pricing change that angered many customers.

As of the end of June, Netflix had 25.56 million subscribers (24.6 million in the U.S., 970,000 in Canada), up 70% from the year-ago period. Netflix expects to add 190,000 to 1.29 million subscribers in the current quarter ending Sept. 30.

On the weak outlook, Netflix's stock was down 9.8% in after-hours trading Monday, dropping $27.53 to $254 per share.

Overall, for the quarter ended June Netflix posted revenue of $789 million -- slightly below analyst expectations of $791.5 million -- and net income of $68 million. Churn in the U.S. business increased to 4.2%, up from 3.9% in the first quarter and 4.0% in the year-earlier period.

Netflix outraged many customers with a price change announced July 12 that amounts to an increase of 60% in fees for those who want both DVDs-by-mail and streaming services. Wall Street analysts said the price change is designed to push subscribers toward the more-profitable streaming-only option.

"We hate making our subscribers upset with us, but we feel like we provide a fantastic service and we're working hard to further improve the quality and range of our streaming content in Q4 and beyond," CEO Reed Hasting and CFO David Wells wrote in a letter to shareholders Monday.

By end of the third quarter in the U.S., Netflix expects 21.6 million to 23.3 million subscribers on the streaming-only plan; 14.6 million to 15.7 million on the DVD subscription plans; and about 12 million taking both.

Average revenue per subscriber declined sequentially, from $11.97 in the first quarter to $11.49 in the quarter ended June 30. Netflix said the average subscription price declined because 75% of new subscribers in the second quarter signed up for the streaming-only plan.

"With the rapid adoption of streaming, DVD shipments for Netflix have likely peaked," Hastings and Wells said in the letter.

The executives said Netflix's "largest competitor over time is likely to be an improved MVPD [multichannel video programming distributor] service offering more Internet video on-demand, and thus reducing the number of people who will be attracted by a supplementary service like Netflix."

Specifically, they called out HBO Go, which lets subscribers of participating affiliates watch HBO on-demand online. "While HBO Go and Netflix do not have overlapping content, and many consumers subscribe to both Netflix and HBO, we do compete with HBO for studio content and for viewers' time. Our task is to consistently improve the quality of our service and stay two steps ahead, so that consumers will continue to enjoy Netflix," Hastings and Wells said.

Netflix also is "mindful of" Hulu Plus and Amazon Prime, the Netflix executives said. However, while Hulu is on the block, Netflix isn't planning to bid on Hulu because "most of its revenue is from providing free ad-supported streaming of current season TV shows, which is not our focus." As for Amazon, they said, "we haven't detected an impact on our business from Amazon Prime."

The Netflix execs also touted that the company's U.S. operating margin was 16.3%, above the company's 14% target and up from 16.0% in the first quarter of 2011. "Going forward in the second half of 2011, we expect to increase our investment in streaming content, thus reaching our 14% domestic operating margin target," they said.

Earlier this month, Netflix said it plans to offer streaming video services in 43 countries across Mexico, Central America, South America and the Caribbean later in 2011.

Netflix now estimates international operating losses in the second half of 2011 of up to $80 million, which includes pre-launch expenses "for the one or more countries we may launch in Q1 2012," the company said.