Netflix Beats on Q2 Earnings, User Base Crosses 50 Million

Netflix Inc. (NFLX) reported an impressive second-quarter 2014. The streaming service provider reported earnings of $1.15 per share that surpassed the Zacks Consensus Estimate by a penny.

Revenues of $1.34 billion were in line with the Zacks Consensus Estimate in the quarter. Most significantly, the company added 1.69 million streaming subscribers (domestic + international), much better than management’s guidance of 1.46 million.

Quarter Details — Revenues

Revenues jumped 25.3% from the year-ago quarter and 5.5% from the previous quarter, primarily driven by higher international revenues (23.0% of revenues), which soared 85.3% year over year and 15.1% quarter over quarter.

Domestic revenues (63.0% of revenues) surged 25.0% from the year-ago quarter and 5.0% from the previous quarter. However, DVD revenues decreased 16.2% year over year and 4.7% on a sequential basis.

Robust subscriber additions in Netflix’s streaming business (domestic + international) led to the year-over-year and sequential improvement in the top line. Notably, the company added 12.36 million paid streaming subscribers over the last 12 months. On a sequential basis, Netflix added 1.85 million paid subscribers in the second quarter.

Total streaming subscriber base increased 12.49 million year over year to 50.05 million. Sequentially, total subscriber growth was 1.70 million. This strong subscriber addition was primarily driven by Netflix’s expanding content portfolio that includes original productions such as House of Cards and Orange is the New Black.

In May, Netflix raised its subscription prices for domestic new subscribers to $8.99, which is a $1.00 hike from the previous pricing plan of $7.99 per month. International new subscribers (Europe and United Kingdom) will be paying a little more than $1.00 due to foreign currency conversions. However, existing subscribers in both the regions will continue to enjoy the current $7.99 plan for the next two years.

The modest price increase reflected Netflix’s cautious approach as it does not want to repeat the 2011 debacle. In Jul 2011, Netflix raised the prices of its combined streaming and DVD-rental package by 60% that enraged customers, resulting in substantial subscriber loss.

We believe that the price hike did not have any material effect on subscriber growth due to Netflix’s superior content portfolio that improved engagement. The company’s growing investments in original program pipeline will continue to play a significant role in limiting any churn due to the price increase.

Netflix recently won 31 nominations for the 66th annual Emmy Awards. Per The Wall Street Journal, the number of nominations won by the company was higher than AMC Network (AMCX), Showtime, Comedy Central and Fox.

Last year, out of 14 nominations, Netflix had won 3 awards. This year, its original show House of Cards received nomination for the second consecutive time in the category of best drama. Netflix’s another original series Orange is the New Black received 12 nominations and will compete for the best comedy award.

Netflix’s strong show pipeline for the third quarter includes the final season of the revived series The Killing, adult animated comedy BoJack Horseman and Mission Blue from the Oscar-winning director of The Cove, Fisher Stevens.

Under its original program initiative, the company has already commissioned Marco Polo whose production has started in Kazakhstan and Malaysia. The other shows that are in production includes Daredevil, the first of the four original series from Marvel Television, Orange is the New Black 3, House of Cards 3, Sense 8, Grace and Frankie, Narcos and an unnamed series from the creators of Damages.

Netflix recently bought the exclusive U.S. video-on-demand rights for CBS Corp’s (CBS) drama series Zoo, set to release in summer 2015. The company recently signed a deal with renowned comedian and actress, Chelsea Handler, to create a new talk-show slated for a 2016 release.

Moreover, Netflix will begin offering streaming services in Germany, Austria, Switzerland, France, Belgium and Luxembourg by September this year. The entry into these markets with 60 million broadband households will significantly expand Netflix’s European presence and total addressable market to over 180 million broadband households.

Margins

Consolidated contribution profit margin (revenues minus the cost of revenues and marketing costs) improved 460 basis points (bps) from the year-ago quarter and 190 bps on a sequential basis to 22.7%.

The strong year-over-year growth in contribution profit was primarily driven by 50.2% surge in domestic contribution profit, which fully offset a 14.6% decline in DVD contribution profit and loss in international streaming segment.

The sequential increase was primarily due to 12.9% increase in the domestic streaming business. Despite heightened marketing activities, international streaming segment reported loss, though much lower.

Marketing expense as a percentage of revenues declined 170 bps from the year-ago quarter and 180 bps from the previous quarter. Technology & development expense as a percentage of revenues decreased 10 bps on both year-over-year and sequential basis.

General & administrative expense as a percentage of revenues increased 40 bps from the year-ago quarter and 10 bps from the previous quarter.

As a result of improving cost structure and higher revenue base, operating income jumped to $129.6 million from $57.1 million in the year-ago quarter. Operating income also increased 32.8% from the previous quarter.

Net income was $71.0 million or $1.15 (better than management’s guidance of $69.0 million/$1.12) compared with $29.5 million or 49 cents in the year-ago quarter and $53.1 million or 86 cents in the previous quarter.

Balance Sheet

At the end of the second quarter, Netflix had $1.71 billion in cash and cash equivalents (including short-term investments) compared with $1.67 billion in the previous quarter. Long-term debt stood at $900.0 million at the end of the quarter.

Netflix generated $56.0 million in cash flow from operations compared with $36.4 million at the end of the previous quarter. The company reported free cash flow of $16.3 million in the quarter.

Outlook

For the third quarter, management forecasts earnings of 89 cents and net income of $55.0 million. The earnings guidance is lower than the current Zacks Consensus Estimate ($1.02) and is much higher than 32 cents per share reported in the year-ago second quarter.

Domestic and international streaming revenues are expected to be $877.0 million and $347.0 million, respectively. Total streaming revenues are expected to be $1.22 billion.

Management expects to add 1.33 million subscribers in the domestic streaming segment and 2.36 million in the international segment in the third quarter of 2014. Netflix expects total subscribers of 53.74 million at the end of the third quarter.

Domestic streaming contribution profit is expected to be $245.0 million. International streaming loss is expected to increase $42.0 million sequentially, due to increased marketing spend. Netflix forecasts operating income of $103.0 million for the third quarter.

Our Take

We believe that Netflix’s impressive second-quarter results, streaming subscriber growth and growth opportunities from international expansion will drive the share price in the near term. However, rising content costs, net neutrality related concerns and intensifying competition are the major headwinds. Netflix has $7.7 billion due for content streaming obligations.

Although the company is lobbying for “strong net neutrality” rules, we believe that it will have no significant effect on major Internet service providers (ISPs) such as Comcast (CMCSA), Verizon (VZ) and AT&T (T), at least in the near term.

Reportedly, the Federal Communications Commission (FCC) plans to investigate the slowdown in Internet traffic. The investigation aims to find the probable cause of bandwidth congestion at the interconnection point of content networks and ISPs.

FCC’s move has received support from all concerned parties as it is expected to enhance transparency over key issues like net neutrality and peering. However, such investigations take a long time to complete and many a times fail to bear any conclusive result. Further, FCC’s new proposed net neutrality rules that will allow ISPs to charge fees for faster connections remains a headwind for Netflix.

Netflix believes that its large customer base will attract government attention to form new net neutrality regulations in favor of content distributors and intermediaries. However, large ISPs will not give up easily, as government intervention is likely to hurt their business model.

Instead, they might try to follow the Comcast and Verizon model, forcing Netflix to enter into similar fee paying arrangements to ensure better streaming quality. Moreover, if the Comcast-Time Warner deal gets approval, Netflix may face significant pressure from the combined entity to increase its annual fees, which will further dent cash balances.

Although Netflix’s measured approach regarding price increase is appreciative, we believe that the cautious step may not be enough to offset the rising operating costs. However, too much aggressiveness may hurt subscriber growth, particularly in international markets amid intensifying competition from the likes of Amazon (AMZN) Prime and HBO.

Nevertheless, we believe that Netflix’s expanding content portfolio, innovative show pipeline for the second half and robust on-demand viewing from international consumers are the major positives that will continue to boost its top line. The partnerships with Virgin Media and TiVo will help Netflix to easily penetrate the European markets, which will be a key growth catalyst, in our view.

Currently, Netflix has a Zacks Rank #3 (Hold).