Netflix Inc.(NFLX) reported second quarter 2011 diluted earnings of $1.26 per share, surpassing the Zacks Consensus Estimate of $1.11 per share and increasing 57.5% from the prior-year quarter.
Earnings also topped management’s guidance range of 93 cents to $1.15.
Quarter in Detail
Total revenue of $788.6 million increased 51.7% from the year-ago quarter but failed to beat the Zacks Consensus Estimate of $791.0 million. However, the total revenue was in the middle of management’s guidance range of $778.0 million to $798.0 million.
On a segment basis, domestic revenue increased 48.1% from the year-ago quarter to $769.7 million and international operations revenue of $18.9 million was at the higher end of management’s guidance range of $16.0 million to $20.0 million.
The year-on-year revenues were primarily boosted by newer additions in the net subscriber base. At the end of the second quarter of 2011, the total number of subscribers (Domestic and International) was 24.6 million, an increase of 64.0% from the prior-year quarter. On a sequential basis, Netflix added 1.8 million new subscribers.
Free subscribers, as a percentage of ending subscribers, decreased to 5.4% from the prior quarter’s 6.1%, but were up from 2.8% reported in the year-ago quarter.
Average monthly revenue per paying subscriber was $11.49 in the quarter, compared with $11.97 in the preceding quarter and $12.29 in the prior-year quarter.
Churn was 4.2% at the end of the quarter, up 30 basis points (bps) sequentially and down 20 bps year over year.
Gross profit increased 45.7% from the prior-year quarter to $298.6 million and gross margin decreased 150 bps to 37.9% on higher costs.
Operating profit increased 48.9% from the year-ago quarter to $115.1 million and was at the lower end of management’s guidance range of $114.0 million to $126.0 million. Operating margin was down 30 bps to 14.6% due to increased spending for streaming content and higher licensing fees.
Net income was $68.2 million, up 56.8% for the previous-year quarter. Net margin was up 20 bps to 8.6% from the year-ago quarter.
Balance Sheet and Cash Flow
Netflix exited the quarter with $376.4 million in cash and cash equivalents (including short-term investments) compared with $342.7 million in the previous quarter.
Long-term debt was $200.0 million at the end of June 30, 2011, and remained flat sequentially.
Cash flow from operating activities was $86.4 million in the second quarter of 2011, compared with $116.3 million in the first quarter of 2011 and $60.3 million in the prior-year quarter and free cash flow was down 25.0% sequentially to $59.5 million.
During the quarter, Netflix used $51.4 million to repurchase 216,000 shares at an average cost of $238.0.
Quarter Ahead
For the forthcoming quarter, management expects EPS to be in the range of 72 cents-$1.07, below the Zacks Consensus Estimate of $1.10 per share. Net income is expected to be in the range of $39.0 million- $58.0 million.
Domestic and International revenue is expected to be in the range of $780.0-$805.0 million and $19.5 million-$23.5 million, respectively.
The Zacks Consensus Estimate projects the revenues for the third quarter to be $846.0 million.
Management expects subscribers in the domestic market and in the international market to range from 24.6 million-25.4 million and 1.1 million-1.4 million, respectively.
Netflix estimates domestic operating income to be between $95.0 million and $120.0 million, while the international business is expected to incur losses in the range of $27.5.0 million to $ 22.5.0 million.
For the third quarter, Netflix expects subscriber mix of US streaming subscribers to be between 21.6 million and 23.3 million. The U.S. DVD subscriber base is expected to be in range of 14.6 million-15.7 million.
Netflix projects the domestic operating margin to be approximately 14.0%.
Netflix expects to add more content to the Canadian service and estimates $1 million contribution loss to $1 million contribution profit in the forthcoming quarter. Additionally, the company estimates international operating losses in the second half of 2011 to be $80 million, which includes pre-launch expenses for one or more countries. These launches are expected in the first quarter of 2012.
Conclusion
We note that except for once, Netflix Inc. has consistently exceeded estimates over the past year or so. The average surprise in the preceding 4 quarters is a positive 9.45%, and thus another positive surprise was expected.
During the quarter, Netflix posted increased revenues and earnings on the back of robust subscriber growth. However, the outlook presented for the forthcoming quarter keeps us cautious, as we anticipate a possible decline in subscriber base due to the new subscription plan structured by Netflix.
Very recently, Netflix announced new subscription plans for its DVD-by-mail and streaming customers. Under the new plan, customers who seek to subscribe for both the DVD-by-mail and streaming services will have to pay $16.00 per month for unlimited access. Previously, Netflix used to charge $10.00 a month for the bundled offering.
However, Netflix’s partnerships with Hollywood studios leads to diversified content and a huge video library, which, enables the company to retain a favorable position compared to its peers.
Netflix intends to expand its business into new territories going forward. Recently, the company announced its plan to launch Internet movie subscription service in Latin America and in the Caribbean.
Moreover, with Netflix concentrating on overseas ventures and content additions, cost escalation in the form of license and renewal fees, as well as necessary technology investments would be a headwind going forward. This would pressurize margins, unless the average monthly revenue per paid subscriber increases.
Additionally, Movie gallery Inc. and Red Box, the kiosk company owned by Coinstar Inc. (CSTR), are also increasing competition for Netflix.
Thus, we have a Neutral recommendation on Netflix’s 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.
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