Don't Believe the Netflix Growth Hype
It looks like Netflix CEO Reed Hastings affirming *December* guidance and apparently Whitney Tilson using this to project 30%-40% yearly growth rates are now back on track has the momos in a tizzy over their favorite play thing once again. Actual guidance for streaming sub growth for Q4 was a loss in October, flat in November and strong gains in December. I find it interesting that Hastings is apparently only affirming December which leaves October and November open for disappointments. None the less I'm here to tell you why improvement in December and even for a few more months is a temporary reprieve and nothing to get excited about.
First off I am assuming the improvement he is talking about is in subscriber growth and not in profitability. I've been following sub trends closely and one that stands out is a comparison of current quarters sub defections to the year ago quarters gross additions. For anyone not familiar with the difference Netflix reports (for one more quarter) gross subs added (how many people signed up for a subscription in a quarter) and net subs (how many total subs did they add or lose in the quarter). You can calculate how many subs dropped thier subscriptions (sub defections) by subtracting net additions or losses from gross additions. I've dug up quarterly sub data over the last couple of years and there is a very clear correlation between current quarter subs losses and the year ago gross additions of almost 100%. For instance if we go back to Q2-11 before Qwickster and the price hike Netflix had 3.35M sub losses to 3.1M gross additions Q2-10. In other words the average subscriber hangs around for about a year before dropping the service. Thus this years sub defections roughly equals last years gross additions. Again this number is very consistent over the couple of years I tracked it and even when there is some deviation it's quickly offset in the following quarters.
In Q3-11 Netflix had 5.5M sub defections vs. 4.1M gross additions in Q3-10. So as expected due to the price hike and Qwickster debacle actual defections ran somewhat ahead of where they would have come in based on trend (~4M defections would have been expected based on trend). Guidance for Q4 was the back end loaded defections of Q3 continued to escalate for a couple of weeks into Q4 but had peaked and were starting to come back down by the time they reported earnings. The important thing to remember here is they lose a whole lot more subs than the headline net loss indicates and it's a consistent number. IE: they didn't "just start losing subs in Q3-11" . Most likely the numbers above trend in Q3-11 and early Q4-11 were pulled forward defections that are going to make defections in December and maybe a couple more months less than trend (because lots of subs who would have left in December-February did so in September-November. There is also a trend of Q4 into Q1 the following year being Netflix strongest for gross additions. If you combine less subs walking because of pull forwards and seasonally strong gross additions and you get a temporary turn around in domestic sub metrics maybe even growth. Nice but not sustainable.
Next we have the international gimmick that IMO is the main reason Hastings made the mad dash into 43 emerging markets going into Q4. As noted above the net sub addition or loss number that makes the headlines is the difference between gross additions and sub defections. The neat trick to going into new markets is there are no sub defections for the first couple of quarters because there are no existing subs to defect. This is going to pump up Netflix net number and I would bet this gimmick is the primary reason he's wasting his time and shareholder money on the 43 lost causes. If you don't believe me just look at Canada, strong net sub additions over the first couple of quarters of the launch have nearly ground to a halt as the early additions are anniversarying and dropping service.
So based on what I'm reading today it looks like the talking points for Q4 are that sub growth made a dramatic turn around in December and all is well with NFLX now. When you understand the dynamics at play the growth is not impressive and not sustainable. Based on some other tea leaves it looks to me like the quarter over all is going to be below guidance however a December turn around with maybe some follow through into early 2012 is going to be spun as the beginning of solid growth again. Don't believe the hype.