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Netflix Inc. (NFLX - Analyst Report) reported strong second-quarter earnings of 49 cents per share, which comfortably surpassed the Zacks Consensus Estimate by 8 cents. Earnings increased significantly from 11 cents reported in the year-ago quarter and from 31 cents in the previous quarter.

However, shares plunged 4.0% in after-hours trading due to lower-than-expected growth in subscriber base.

Revenues

Although revenues jumped 20.3% year over year to $1.07 billion, it lagged the Zacks Consensus Estimate. Sequentially, the revenue growth was a modest 4.4%.

Robust subscriber additions in Netflix’s streaming business (both domestic and international) led to the year-over-year improvement in top line. Notably, Netflix’s paid streaming subscriber base (both domestic and international) increased 38.6% on a year-over-year basis to 35.6 million. Sequentially, the paid subscriber base increased 4.1%.

Total streaming subscriber base increased 36.3% to 37.6 million. Sequentially, total subscriber growth was up a modest 3.4%. Moreover, the company witnessed strong growth in Brazil despite its price rise from 15 BRL to 17 BRL.

At the end of the second quarter, revenues from Netflix’s domestic streaming business increased 26.0% from the year-ago quarter to $671.1 million (management guidance was $664.0 million - $673.0 million). Sequentially, revenues increased 5.1%.

Revenues from international streaming business were up a staggering 155.3% year over year to $165.9 million (management guidance was $156.0 million - $170.0 million). Sequentially, revenues increased 16.8%.

However, Netflix’s DVD business continued its declining trend in the second quarter as well. Revenues declined 20.3% year over year to $232.4 million in the quarter. Sequentially, revenues decreased 4.5%.Total subscriber base declined to 7.5 million from 9.2 million in the year-ago quarter.

Operating Results

Operating profit for the quarter jumped 253.6% year over year to $57.1 million, primarily due to higher revenues. Additionally, lower-than-anticipated content spending also helped operating results.

Contribution profit from domestic streaming segment increased 73.0% year over year to $151.3 million. Contribution loss from international streaming segment was down from $89.5 million to $65.8 million. Contribution profit from Netflix’s DVD business declined 18.8% year over year.

Expenses were up 16.0% year over year, primarily due to higher cost of revenue (17.1% year over year), technology expenses (14.2% year over year) and general and administrative expenses (28.7% year over year). Marketing expenses increased 6.8% on a year-over-year basis.

Net income for the quarter was up from $6.2 million to $29.4 million.

Balance Sheet

Exiting second-quarter 2013, Netflix had $1.08 billion in cash and cash equivalents (including short-term investments) compared with $1.03 billion in the previous quarter. Long-term debt stood at $500.0 million at the end of quarter under review.

Netflix had $33.9 million in cash flow from operations. The company reported free cash flow of $12.9 million.

Guidance

For the third quarter, management forecasts earnings per share between 30 cents and 56 cents. Net income is expected in the range of $18.0 million to $34.0 million.

Domestic and International streaming revenues are expected in the range of $693.0 million - $701.0 million and $170.0 million - $184.0 million, respectively.

Management expects total subscribers in the domestic streaming market and in the international streaming market in the band of 30.5 million to 31.3 million and 8.3 million to 9.0 million, respectively.

Netflix is expected to step up its spending on contents in the fourth quarter, which will impact margins.

Recommendation

Netflix reported a better-than-expected quarter on the back of higher subscription additions and provided an encouraging guidance. Moreover, new streaming content additions through licensing deals will help the company to counteract stiff competition from other service providers such as Amazon (AMZN - Analyst Report), HBO, Verizon (VZ - Analyst Report) and Comcast (CMCSK - Snapshot Report).

However, Netflix’s continuous subscriber loss in its DVD business can be a headwind going forward. Moreover, the company’s increase in content spending is expected to impact margins in the near term.

Currently, Netflix has a Zacks Rank #1 (Strong Buy).

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