Netflix Inc. (NFLX) reported first quarter 2011 diluted earnings of $1.11 per share, surpassing Zacks Consensus Estimate of $1.07 per share and increasing 88.1% from the prior year quarter.
Earnings were at the higher end of management’s guidance range of 90 cents to $1.13.
Quarter in Detail
Total revenue of $718.5 million increased 45.6% from the year ago quarter and easily surpassed the Zacks Consensus Estimate of $703.0 million. The revenue also exceeded guidance range of $684.0 million to $704.0 million.
On a segment basis, domestic revenue increased 43.0% from the year-ago quarter to $706.3 million and revenue of $12.3 million from international operations was at the high end of management’s guidance range of $10.0 million to $13.0 million.
Revenues for the quarter were primarily boosted by additions in the net subscriber base. At the end of the first quarter of 2011, the total number of subscribers (Domestic and International) increased by a net 3.6 million sequentially and by 9.6 million from the year-ago quarter to 23.6 million.
Free subscribers, as a percentage of ending subscribers, decreased to 6.1% from the prior quarter’s 8.0% and 2.5% in the year-ago quarter.
Average monthly revenue per paying subscriber was $11.97 in the quarter, compared with $11.68 in the preceding quarter and $12.90 in the prior-year quarter.
Churn was 3.9% at the end of the quarter, up 10 basis points (bps) sequentially and down 10 bps year over year.
Gross profit increased 50.3% from the prior-year quarter to $280.4 million and gross margin increased 120 bps to 39.0% on higher volumes.
Operating profit increased 75.3% from the year-ago quarter to $102.2 million and was within management’s guidance range of $98.0 million to $116.0 million. Operating margin also improved 240 bps to 14.2%.
Net income was $60.2 million, up 87.2% on a yearly basis. Net margin grew 190 bps to 8.4% from the year-ago quarter.
Balance Sheet and Cash Flow
Netflix exited the quarter with $342.7 million in cash and cash equivalents (including short-term investments) compared with $350.4 million in the previous quarter.
Long-term debt was $200.0 million at the end of March 31, 2011, and remained flat sequentially.
Cash flow from operating activities was $116.3 million in the first quarter of 2011, compared with $96.7 million in the fourth quarter 2010 and $77.2 million in the prior-year quarter.
Free cash flow was $79.3 million, up 55.0% sequentially. The sequential increase was driven by higher net income, higher non-cash stock compensation expense, no interest payment in the quarter, and lower cash taxes, which were partially offset by a smaller increase in deferred revenue.
During the quarter, Netflix used $108.6 million to repurchase 502,000 shares at an average cost of $216.48.
Quarter Ahead
For the forthcoming quarter, management expects EPS to be in the range of 93 cents to $1.15, below the Zacks Consensus Estimate of $1.18 per share. Net income is expected to be in the range of $50.0 million to $62.0 million.
Revenue for the second quarter reported as domestic and international is expected to be in the range of $762 to $778 million and $16.0 million to $20.0 million, respectively.
Management expects subscribers in the domestic market to be between 24.0 million and 24.8 million. Subscribers in the international market are estimated to be between 0.9 million and 1.1 million.
Netflix estimates domestic operating income to be between $100.0 million and $116.0 million, while the international business is expected to incur losses in the range of $14.0 million to $ 10.0 million.
Netflix projects the domestic operating margin to be approximately 14.0% and expects the Canadian operations to have a positive impact on operating margins starting from the third quarter of 2011. In the latter half of 2011, management expects international operations to incur operating losses of approximately $50 million to $70 million.
Conclusion
Analyst estimates remained unchanged in the run-up to the earnings release (in the last 7 days). At the time of the earnings report, the average estimate was $1.07. We note that Netflix Inc. has consistently exceeded estimates over the past year or so. The average surprise in the preceding 4 quarters is a positive 10.83%, another positive surprise was therefore expected.
We believe that Netflix’s migration from the mail-order DVD rental business to a content-rich online movie streaming company will prove to be a positive for the company, since online streaming does not require handling and mailing charges. Therefore, the company does not have to bear any related costs.
The successful strategizing and robust results in the first quarter are attributable to Netflix’s strong subscriber base. Netflix is focused on becoming an entertainment powerhouse by content additions to its already vast and varied library, through partnerships with big production houses like Paramount Pictures and Twentieth Century Fox, to name a couple.
We also believe that these content additions will enable Netflix to reduce its dependence on cable TV operators and also provide the necessary competitive edge over its peers in the emerging market of online video streaming. Netflix has been gaining rights of few original series and its partnership with the big houses reflects the financial prowess of the company.
Of course, with larger players beginning to show interest in this emerging market of online video streaming, Netflix will face incremental competitive pressures from Amazon.com Inc. (AMZN), Apple Inc. (AAPL) and Google Inc. (GOOG), as well as from cable operators.
Additionally, Movie gallery Inc. and Red Box, the kiosk company owned by Coinstar Inc. (CSTR), are also increasing competition for Netflix.
Moreover, Netflix plans to expand its business beyond Canada and into two new countries by early 2012. The company is also spending to gain rights to films and TV shows outside the U.S. and we expect the margins will be under pressure due to expansion costs on the international front.
Thus, we have a Neutral recommendation on Netflix shares in the long term.
We currently have a Zacks #2 Rank for Netflix Inc., which translates into a Buy rating in the short term, aided by the robust quarterly results.
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