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Netflix Beats Earnings; Down on Weak Subscriber Growth

Shares of Netflix Inc. (NFLX) plunged 26.4% ($118.59) in after-hours trading on the heels of lower subscriber addition in the third quarter and a lackluster fourth-quarter 2014 earnings outlook.

Netflix added 3.02 million streaming subscribers (domestic + international), which missed management’s guidance of 3.69 million. For the upcoming fourth quarter, Netflix expects net addition of 0.80 million subscribers, negatively impacted by growing competition from HBO.

The streaming service provider reported earnings of 96 cents per share that surpassed the Zacks Consensus Estimate by a nickel. Revenues of $1.41 billion were in line with the Zacks Consensus Estimate in the third quarter.

Quarter Details — Revenues

Revenues jumped 27.4% from the year-ago quarter and 5.1% from the previous quarter, primarily driven by higher international revenues (25% of revenues), which soared approximately 89% year over year and 12.4% quarter over quarter.

Domestic revenues (62% of revenues) improved 25.1% from the year-ago quarter and approximately 5% from the previous quarter. However, DVD revenues decreased 16% year over year and 4.2% on a sequential basis.

The revenue growth was primarily driven by $1 price increase, which Netflix implemented in the second quarter. However, lower subscriber addition in the reported quarter was also attributed to this price rise.

Notably, the company has added 12.64 million paid streaming subscribers over the last 12 months. At the end of the third quarter, total streaming subscriber base increased 12.78 million year over year to 53.06 million. Sequentially, total subscriber growth was 3.01 million.

This growth was primarily driven by positive response for popular shows like Orange is the New Black 2, BoJack Horseman and Hemlock Grove 2. The company also streamed the final season of the revived series The Killing during the quarter.

Netflix inked a number of expensive deals like the popular Sony Pictures-produced NBC drama The Blacklist, for which it paid $2 million per episode. The company also bought the exclusive video-on-demand rights for Fox’s drama series Gotham, which premiered on Sep 22. Netflix reportedly paid more than $1.75 million per episode for the show.

In July, Netflix bought the exclusive U.S. video-on-demand rights for CBS Corp’s (CBS) drama series Zoo, set to release in summer 2015. Reportedly, Netflix is paying more than $1 million than what Amazon.com (AMZN) paid for each episode of Under the Dome and Extant.

Netflix’s upcoming productions like Marco Polo, Grace and Frankie and kid shows like The Magic School Bus 360 degrees is expected to add new subscribers while retaining the existing ones. Not only dramas and comedy, the company is also looking to expand its documentary and chat show portfolio.

Netflix signed a deal with renowned comedian and actress, Chelsea Handler, to create a new talk-show slated for a 2016 launch. The deal also includes a stand-up special along with four docu-comedy specials, all featuring Handler.

Netflix’s partnership with Walt Disney’s (DIS) Marvel Entertainment is set to bring at least four new 13-episode series and a mini-series based on characters such as Daredevil, Jessica Jones, Iron Fist and Luke Cage on Netflix, beginning 2015.

Apart from adult shows, Netflix is increasingly focusing on steaming kids’ shows, which have tremendous growth potential. The company recognizes the fact that kids make up a significant chunk of TV show and film viewers. Netflix currently offers 75 kids series and its viewer base is approximately 2 million, while some shows have more than 5 million viewers.

To attract kids, Netflix is working with DreamWorks Animation to include original cartoon series in the service and has a similar deal with Mattel. In the fourth quarter, Netflix is set to launch two original series from DreamWorks Animation, Veggie Tales and All Hail King Julien.

Recently, European animation studio Rainbow and the company announced a new kid series, Winx Club WOW: World of Winx, exclusively for Netflix subscribers including France and Germany. The first of the two all-new seasons will be available by early 2016.

Netflix’s partnerships with major film studios and production houses like The Wachowskis (creators of The Matrix trilogy), J. Michael Straczynski (Babylon 5), Gaumont International, Sony Pictures, The Weinstein Company and Walt Disney are also expected to further expand its content library in 2014 and beyond.

Netflix began offering streaming services in Germany, Austria, Switzerland, France, Belgium and Luxembourg in September this year. The entry into these markets with 66 million broadband households is expected to significantly expand Netflix’s European presence and total addressable market to over 180 million broadband households.

The partnerships with SFR in France, Deutsche Telekom in Germany, Orange and Bouygues in France and Belgacom in Belgium are expected to further drive international subscriber base over the long run.

Most recently, Netflix signed a distribution deal with The Weinstein Company (“TWC”), which will enable it to stream the sequel of Crouching Tiger, Hidden Dragon simultaneously with the film’s release at selected IMAX theatres on Aug 28, 2015.

The company also signed a four-film deal with renowned Hollywood actor, Adam Sandler. All the four films will exclusively premiere on Netflix.

Margins

Consolidated contribution profit margin (revenues minus the cost of revenues and marketing costs) improved 400 basis points (bps) from the year-ago quarter but contracted 70 bps on a sequential basis to 22%.

The strong year-over-year growth in contribution profit was primarily driven by 50.7% surge in domestic contribution profit, which fully offset a 16.2% decline in DVD contribution profit and loss in international streaming segment.

The sequential contraction was primarily due to a 10.4% increase in the domestic streaming revenues. International streaming segment loss increased on a sequential basis, due to higher expenses.

Marketing expense as a percentage of revenues increased 50 bps from the year-ago quarter and 130 bps from the previous quarter. Technology & development expense as a percentage of revenues remained flat on both year-over-year and sequential basis.

General & administrative expense as a percentage of revenues increased 130 bps from the year-ago quarter and 100 bps from the previous quarter.

Operating margin expanded 260 bps from the year-ago quarter but contracted 210 bps sequentially to 7.8%. The contraction was primarily attributed to higher marketing expense.

Net income was $59.3 million or 96 cents per share (better than management’s guidance of $55 million/89 cents per share) compared with $32 million or 52 cents in the year-ago quarter and $71 million or $1.15 in the previous quarter.

Netflix, Inc - Earnings Surprise | FindTheBest

Balance Sheet

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

Cash outflow from operations were $37.4 million compared with $56 million at the end of the previous quarter. The company reported free cash outflow of $73.7 million in the quarter.

Netflix’s total streaming content obligations increased to $8.9 billion in the quarter from $7.7 billion at the end of second quarter.

Outlook

For the fourth quarter, management forecasts earnings of 44 cents and net income of $27 million. The earnings guidance is lower than the current Zacks Consensus Estimate ($1.02) and 79 cents per share reported in the year-ago comparable quarter.

Domestic and international streaming revenues are expected to be $917 million and $388 million, respectively. Total streaming revenues are expected to be $1.31 billion.

Management expects to add 0.98 million subscribers in the domestic streaming segment and 2.04 million in the international in the fourth quarter of 2014. Netflix expects total subscribers of 57.06 million at the end of the fourth quarter.

Domestic streaming contribution profit is expected to be $260 million. International streaming loss is expected to increase to $95 million on a sequential basis, due to increased marketing spend. Netflix forecasts operating income of $57 million for the fourth quarter.

Our Take

Despite an unimpressive third quarter and lackluster fourth-quarter guidance, we believe that Netflix has strong growth potential from international expansion and diversified content portfolio. The company’s venture into movie distribution will also boost its subscriber base over the long run.

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, Verizon and AT&T, at least in the near term.

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.

However, rising content costs, net neutrality related concerns and intensifying competition are the major headwinds.

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

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