Netflix, Inc. (NASDAQ:NFLX) released its earnings report for the third quarter of 2013 yesterday afternoon to great applause. The company beat expectations and showed better than expected metrics in several areas. The stock hit new highs and will open on Tuesday at close to 8% higher than it closed on Monday afternoon. There may be problems housed in the report, however.


International subscription growth came in exceptionally well for the company in the third quarter. The firm added 1.1 million subscribers in international markets, higher than consensus expectations of 900,000. The company highlighted its original content as a key driver of growth both in the United States and abroad, but that growth comes at a cost. For once that cost is material, and numerable.

Netflix gross margin problem

Netflix, Inc. (NASDAQ:NFLX) revealed that it missed consensus gross margin estimates for the third quarter. Analysts expected the company to record a gross margin of around 29.5%, the same number the firm recorded in the second quarter. The firm’s gross margin actually came in at 28.5%.

The reason for the gross margin miss was, according to Netflix, Inc. (NASDAQ:NFLX), partly due to the paying off of debt associated with the company’s original content production. Original content is expensive, but Netflix values it above almost anything else for its user growth. Going forward Netflix is likely to produce more original content to attract more users.

Costs for original content are likely to spiral upward in the quarters to come. It will not kill Netflix, Inc. (NASDAQ:NFLX) by any means, but it will eat into the company’s gross margin and its earnings. For a company as highly valued as Netflix, that might represent a problem.

Netflix valuation and future growth

Netflix, Inc. (NASDAQ:NFLX) will be valued at more than 400 times 2012 earnings when the market opens later today. The firm’s share price has been driven by a rise in earnings, but most of it is still based in the company’s ability to grow earnings. Netflix has a Revenue Per User problem. Coupled with rising costs, that could hurt growth prospects.

Netflix, Inc. (NASDAQ:NFLX) uses blanket pricing. In order to grow it will need to keep pricing consistent. Unless it can find a way to increase revenue per user, the company’s earnings potential may fall as costs rise. It’s a difficult time for the company’s investors. They will need to evaluate the balance of gross margin and profits for themselves.