Netflix and Amazon aren't as bad off as it seems

October 26, 2011: 3:17 PM ET

Investors were caught off guard by results at Amazon and Netflix. Truth is, if they'd been paying closer attention, they'd have seen it coming.

By Kevin Kelleher, contributor

Reed Hastings

Reed Hastings

FORTUNE – This fall's earnings season is starting to look like hunting season for big-name web companies. First, Netflix drops 35% in one day, Tuesday, after heavy subscriber losses and warning investors that it would lose money for a few quarters next year. Then Amazon said its profit fell 73% in the third quarter of 2011. In after-hours trading, Amazon's stock fell nearly 15%.

Taken together, the stocks of Amazon (AMZN) and Netflix (NFLX) lost nearly $18 billion in market value over the course of 24 hours -- nearly equal to Yahoo's (YHOO) entire $20 billion market cap. Just as remarkable was the fact that both companies posted revenue growth rates that many tech companies would envy: Amazon's net sales grew 44% to $10.9 billion and Netflix's figure rose 49% to $822 million.

How can investors punish stocks that are enjoying such rapid growth? The answer has to do with how much it is costing them to generate that growth. Amazon's profit crumbled last quarter because of spending on its Kindle Fire tablet. Netflix is racing to add new titles to its library while expanding internationally. Both moves promise to expand revenue in the long-term while cutting profits or even generating losses in the near term.

As is often the case, when Wall Street is caught off guard, analysts respond in a dramatic fashion. Several wagged disappointed fingers at Netflix, while one bemoaned the "nuclear winter" it faces. Amazon's profit miss, meanwhile, left some investors scratching their heads.

But the truth of the matter is, if analysts and investors didn't see Amazon's and Netflix's profit issues coming before this week, it was only because they weren't paying very much attention.

For any investor familiar with the histories of these respective companies, these moves shouldn't come as a surprise. Both Amazon and Netflix have a history of making bold bets on future growth that often involve heavy spending up front. And both companies have a history just as long of proving their naysayers and bearish critics wrong.

Jeff Bezos

Jeff Bezos

What's more, investors should have seen the bad news coming. Both companies had been telegraphing clearly their plans to grow revenue at the expense of profit margins. Amazon said the Kindle Fire tablet would retail for $199, or about $20 below its estimated manufacturing cost. So why were people surprised when Amazon said the Kindle Fire could lead to an operating loss this quarter?

Similarly, few panicked when Netflix said Monday morning that it would expand into the U.K. and Ireland in early 2010, following its expansions into Canada and Latin America. The online video market is already competitive in the U.K., where 60% of the 20 million homes with broadband already subscribe to video offerings from Sky and Virgin. So subscriber growth will understandably be slower at first, taking longer for Netflix's operations to become profitable. But when Netflix pointed this out later on, investors panicked.

Of course, there's a lot more to Netflix' decline than the costs of its expansion abroad. The stock has lost three-quarters of its value since July, when it botched a series of moves to increase fees and separate DVD and streaming operations, leaving customers annoyed if not angry.

Netflix warned investors of a wave of cancellations in July. Back then, Netflix said that many customers wouldn't have to pay the new subscription fees until September. So it should have been evident that there would be another wave of cancellations once these fees showed up on credit card statements. But many analysts seemed surprised at the 800,000 cancellations.

Even with those cancellations, Neflix saw the number of its unique U.S. subscribers last quarter grow 42% year over year. That's down from the 64% growth rate in the previous quarter, but it's comparable with Netflix overall subscriber growth in 2010. And again, how many companies can whether the kind of PR fiasco Netflix endured this summer and still see U.S. subscribers grow so quickly?

Another fatal miscalculation that investors made was to grow so complacent with the steady stock gains from both Amazon and Netflix that they lost sight of the risk inherent in generating growth. At its peak this summer, Netflix had risen more than 3,000% from its 2002 debut price. At Tuesday's close, Amazon was showing a 2,700% gain over the past 10 years.

Neither stock could do no wrong, so that both became darlings of the tech sector. That left both companies with irrational, indefensible valuations: Netflix traded at 85 times earnings at its July peak, and Amazon on Tuesday had a price-earnings ratio above 100. The average PE ratio of the S&P 500's stock is 15.

Such high valuations can't last forever, and so both stocks are falling back to earth. What's ironic is that the trigger for the declines are plans by both companies to lay the groundwork for new growth in coming years. It's one thing to take profits when a growth company warns that new spending will hurt profits. It's another to sell out of panic. The panic sellers in Amazon and Netflix this week may regret their impulsive moves if the spending starts to bear fruit.

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