Netflix Earnings – Behind the Headlines

By Chad Henage - April 30, 2012 | Tickers: AMZN, NFLX | 0 Comments

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One thing you can say for Netflix (NASDAQ: NFLX) is the story is never boring. In just the last five days the stock has traded down nearly 19%. Of course everyone knows that most of this was due to the huge selloff right after the company reported earnings. In case you read the headlines, and ran for the hills without digging into the numbers, let me walk you through what I see is going on with the company. Since I would rather draw my own conclusions, I use the company's quarterly report as a reference. Chances are if you see me quoting a number, it can be found in the report here. 

First, and very surprising, the company expects to return to global profitability in the second quarter. I'll be honest, I didn't think that would happen. Netflix did say also that it would launch its next international market in the fourth quarter as well. This is management's expectation going forwar: launch new territories while trying to keep global profitability. Netflix management believes that longer-term this first mover advantage will allow the company to create substantial value. Let's look at what else Netflix had to say in its recent earnings, to find out if this recent drop is a buying opportunity or a warning signal.

Netflix operates three different segments: domestic streaming, international streaming, and domestic DVD. As of the most recent quarter, the company had 23.41 million total subscriptions to its domestic streaming service. From these total subscribers, Netflix generated $507 million in revenue, or about $21.66 per subscriber. The company also said, they expect to gain about 7 million net additions for 2012. Netflix went to great lengths to explain what happens with the seasonality of their business. Management is trying to prepare both analysts and investors, that the second quarter is historically the weakest when it comes to subscriber additions. This seasonality could lead to surprisingly higher additions going into the third and fourth quarters. If Netflix ends the year with these additional 7 million subscribers, at a constant $21.66 per subscriber, the domestic streaming business should generate at least $621 million in revenue a quarter by the end of the year.

International streaming is comprised of three different segments: U.K. and Ireland, Canada, and Latin America. In total, the company has about 3 million international streaming customers. In Canada, Netflix is expecting a small profit contribution, but that the country's operations will remain profitable. The U.K. and Ireland business clearly has the company excited as the company saw, “the highest net additions we've ever seen in the first 90 days of an international market launch.” The fact that in the U.K. and Ireland, customers are already familiar with streaming makes Netflix another choice. The “problem child” that Netflix has is Latin America. The three big issues are: low use of credit cards, limited understanding of streaming, and low device penetration. These are all critical factors in Netflix gaining traction, and will take time to develop. With a loss of about $100 million in this last quarter, the company thinks this is as bad as it gets, and is forecasting smaller losses going forward. For now we'll assume the company averages 40% growth quarter-to-quarter in subscribers (this is about half of the prior growth rate). This would indicate just over 8 million international subscribers by the end of 2012. These 8 million subscribers would generate about $114 million in revenues given similar run rates.

Domestic DVD is the forgotten division at Netflix. The fact that the company expects DVD subscribers to decline quarterly forever is telling. The percentage of decline is a little hard to calculate since the company did not always break out its numbers. In the short period, where we do have a breakout of DVD subscribers, we see the following:

I would project a 5% runoff rate going forward as a realistic ongoing number. With this runoff rate, we could expect about 8.75 million DVD subscribers by the end of 2012. These subscribers would generate about $275 million in revenues by the end of the year.

If you add it all up, before Netflix launches its next international business, the company could generate about $1 billion in revenues per quarter by the end of 2012. With 55.4 million shares outstanding, Netflix at this revenue amount would need just a 3% net margin to meet 2013 estimates of $0.10 per share. Considering that Netflix has averaged a 6-7% net margin in the past few years, management just needs to be smart about not overspending when entering new markets. If the company takes a slower approach, Netflix could beat estimates easily.

It's ironic that Amazon.com (NASDAQ: AMZN) spends money regularly to expand the business, and the company is not afraid to report much lower earnings to try to take important markets. As a good example, Amazon recently reported substantially lower earnings versus last year, and projected a small profit to a loss next quarter. It's ironic that higher sales from digital are what investors are cheering Amazon for. Netflix management seems to be willing to make the same type of short term sacrifice for hopefully longer-term gains in streaming media. Where Amazon is a competitor and gets credit for investing for the future, Netflix gets slammed for overspending. If you are a buyer of Netflix, you need to be willing to hold the stock for at least a few years. While this year appears to be a transition year, next year the company should be able to have decent earnings again. The first time Netflix was at current prices in the low $80s was April 2010, but the company had half the subscribers of today. With twice as many paying subscribers today and the same price, it seems like this could be a good entry point. Let me know what you think in the comments section below.

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