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Netflix Original Shows: A Costly Mistake?

Why did Netflix stock (NFLX) drop as much as 7% in after-hours trading Monday?

Netflix reported revenue of $1.07 billion for the second quarter and earnings per share of 49 cents. Wall Street analysts were expecting $1.07 billion and 42 cents per share. Stocks on a run-away rally -- and Netflix had nearly tripled this year -- are fueled by rising expectations. Apple (AAPL) got to be a $700 stock by smashing analysts’ expectations again and again. It fell back to earth as its profit margins and profit growth slowed.

With Netflix, expectations grew that the debut of the new season of "Arrested Development" would fuel a major surge in U.S. subscriptions. Netflix's second quarter hasn’t typically been strong but some analysts and investors were expecting 900,000 or more new subscribers. Instead Netflix got 630,000 new signups, about the same as a year ago. Its guidance for the third quarter was also not as strong as some hoped at about 1.1 million.

Does that mean Netflix’s strategy to create original shows, like "House of Cards" and "Arrested Development," was a costly mistake?

It's too soon to say. Netflix says all five of its originals have been a success and each has debuted to higher first week viewership than its predecessors, including the most recent, "Orange Is the New Black," this month. But Netflix won’t give out any specific viewership numbers. Head of Content Ted Sarandos said on Monday that all the shows are drawing “TV-sized audiences.”

“You know that 'House of Cards' is a hit because when you walk in to Starbucks and people are talking about it,” he added. “You know when the show's being spoofed at the White House Correspondents' Dinner and 3,000 people are laughing at the slightest references to the show, you know that people are watching it and you know people are talking about it.”

Related: 'Originals' seen lifting Netflix profits--for now

The whole point of the originals is to create exclusive programming for Netflix that’s not widely available on regular TV – long-running, serial dramas with slow developing story lines. The most watched series on Netflix are AMC's "Mad Men" and "Breaking Bad," according to a recent survey. But none of Netflix's new originals have built up multiple seasons yet. "Seinfeld" and "The Sopranos" each took several seasons before becoming wildly popular, Sarandos pointed out. Netflix CEO Reed Hasting said he hoped that by season four or five, the shows would become “a Harry Potter-esque global phenomenon.” That will be the true test.

With all the pressures on Netflix from increasing content costs and growing competition, can Netflix increase its popular $7.99 a month price? CEO Reed Hastings certainly plans to. Asked repeatedly on the investor video, Hastings stuck by the current pricing as creating the best balance of profits and growth.

“We're very comfortable where we are at the $7.99 price point,” he said more than once.

And the current pricing is working, he argues. Despite rising programming costs and competition, Netflix's U.S. business has shown increasing profitability and the profits are being used to kick-start the international side of the business, Hastings said.

“There’s plenty of evidence that we can grow revenue faster than content costs,” he added.

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