Netflix Beats Despite Y/Y Decline

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Netflix Inc. (NFLX) reported second quarter 2012 earnings of 11 cents that surpassed the Zacks Consensus Estimate of 4 cents. Reported earnings were at the higher end of management’s guided range of (10 cents) to 14 cents. However, earnings plummeted from $1.26 per share from the previous-year quarter.

Quarter Details

Total revenue increased 12.8% year over year to $889.2 million and whisked past the Zacks Consensus Estimate of $889.0 million. The year-on-year revenue growth was primarily boosted by newer additions in the total subscriber base. At the end of second quarter 2012, total number of subscribers (Domestic and International) was 30.1 million, an increase of 17.8% from the prior-year quarter.

Despite the increase in subscribers in Netflix’s streaming business (both in domestic and international markets), the company’s DVD business continued to lose subscribers.

Domestic revenue (streaming and DVD) increased 7.1% from the year-ago quarter to $824.2 million, which was within management’s guided range of $813.0 million to $828.0 million.

Netflix’s International streaming business generated revenues of $64.9 million, significantly higher than $18.9 million in the previous-year quarter. The revenue was within management’s guided range of $60.0 million to $67.0 million.

Gross profit decreased 17.7% from the year-ago quarter to $245.7 million. Gross margin decreased from 37.9% in the year-ago quarter to 27.6% due to the 36.3% year-on-year jump in subscriber costs.

Operating expenses shot up 25.1% year over year to $229.6 million, due to higher marketing expenses (up 24.5% year over year), technology and development expense (up 40.8% year over year), which offset the 2.9% decline in the general and administrative expense during the quarter.

Operating profit for the quarter was $16.2 million, down from an operating profit of $115.1 million in the previous-year quarter. Operating margin for the quarter was down from 14.6% in the previous-year quarter to 1.8% due to higher operating costs.

Net income for the quarter was $6.2 million down from $68.2 million earned in the previous-year quarter. Net margin was 0.7% in the reported quarter versus 8.6% in the previous-year quarter. Decline in contribution profits in the DVD business and loss from the international business dragged the net margin down.

Exiting second quarter 2012, Netflix had $813.3 million in cash and cash equivalents (including short-term investments) compared with $804.5 million in the previous quarter. Long-term debt remained at $200.0 million at the end of second quarter 2012.

Cash flow from operating activities was $19.7 million in the second quarter of 2012, compared with $19.1 million in the first quarter of 2012. Free cash flow was $11.2 million, up from $2.1 million in the previous quarter.

Quarter Ahead

For the forthcoming quarter, management forecasts the loss/earnings per share to be between (10 cents) to 14 cents. The Zacks Consensus Estimate is pegged at a loss of 11 cents per share. Net income is expected to be in the range of ($6.0 million) to $8.0 million.

Domestic and International streaming revenue is expected to be in the range of $552.0 million to $559.0 million and $72.0 million to $79.0 million, respectively. Domestic DVD revenue is expected to be in the range of $266.0 million to $273.0 million for the third quarter of 2012.

Management expects subscribers in the consolidated domestic market and in the international market to range from 24.9 million to 25.7 million and 3.9 million to 4.4 million, respectively. The U.S. DVD subscriber base is expected to be in the range of 8.35 million to 8.65 million.

Management believes that the subscriber decline in the DVD business will continue in the forthcoming quarters. However, strong subscriber growth in the streaming business in both US and International markets will limit the decline in customer business in 2012.

Nevertheless, the company noted that the Olympic Games in July will hamper customer acquisition across its international markets. Moreover, Netflix hinted on European expansion in the fourth quarter of 2012. Management also hinted that costs related to the content additions will result in international streaming operations’ loss on a sequential basis.

Our Recommendation

Although Netflix reported better-than-expected second quarter results, we believe that earnings growth will take some time to rebound. Despite the higher costs, we believe Netflix will probably see sales strengthening, as subscribers take note of the improving portfolio. This would ultimately enable the company to build a position for itself over the long term.

Netflix’s offering of new and exclusive contents to its subscribers is its biggest USP compared to some of its closest peers. Apart from recent movies and documentaries, Netflix is also boosting its original content portfolio to entice new subscribers in the US and International markets.

With its own content delivery network, Open Connect, Netflix’s video library will be directly connected to Internet service providers, ensuring smooth and fast data transfer that would eventually enrich the customer experience.

However, higher capital expenditure due to international expansion will hurt earnings growth in the near term, in our view. When compared to some of its cable and communications peers that have diversified revenue and cash flow streams, Netflix relies solely on streaming for future growth, as its DVD rental business continues to lose subscribers. Moreover, increasing competition from Amazon.com Inc. (AMZN) will remain an overhang on the stock going forward.

We have a Neutral recommendation on Netflix over the long term. Currently, Netflix has a Zacks #3 Rank, which implies a Hold rating over the short term.

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