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Netflix, Inc. (NFLX), Apple Inc. (AAPL): This Company’s Virtuous Circle Can Only Grow so Far

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Reed Hastings and Tim CookNetflix, Inc. (NASDAQ:NFLX) announced solid earnings for the second quarter, but didn’t add enough subscribers to appease Wall Street’s expectations. The shares fell. Although the company continues to add subscribers, there will come a point when its mature markets are saturated. Investors could jump ship fast when that happens.

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.

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