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Shares of Netflix Inc. (NFLX - Analyst Report) surged 11.3% ($40.00) to $394.99 in after-hours trading on the heels of impressive third quarter 2013 results. Netflix’s earnings of 52 cents per share comfortably beat the Zacks Consensus Estimate by 4 cents.  

Revenues of $1.11 billion were also slightly ahead of the Zacks Consensus Estimate of $1.10 billion in the quarter. Most significantly, the company added 1.28 billion domestic subscribers, much better than management’s guidance of 1.09.

In the last quarter, international streaming business segment added 1.44 billion subscribers, well ahead of management’s guidance of 0.90 billion.

Revenues

Revenues jumped 22.2% from the year-ago quarter, primarily driven by higher international revenues (17.0% of revenues), which surged 135.5% year over year to $183.1 million in the reported quarter.

Domestic revenues (63.0% of revenues) increased 26.1% from the year-ago quarter to $701.1 million. However, DVD revenues plunged 18.2% year over year to $221.9 million.

Revenues climbed a modest 3.4% from the previous quarter, based on a 4.5% increase in domestic revenues and a 10.3% jump in international revenues, which fully offset a 4.5% decline in DVD revenues.

Robust subscriber additions in Netflix’s streaming business (both domestic and international) led to the year-over-year and sequential improvement in the top line. Notably, the company added 10.52 million paid streaming subscribers over the last 12 months. On a sequential basis, Netflix added 2.38 million paid subscribers in the third quarter.

Total streaming subscriber base increased 10.87 million year over year to 40.28 million. Sequentially, total subscriber growth was 2.72 million.

This strong subscriber addition was primarily driven by Netflix’s expanding content portfolio that includes original productions such as Orange is the New Black, as well as the complete seasons of popular shows from other production houses such as AMC.

Notably, Netflix’s original show House of Cards won a Primetime Emmy Award, as the first fully web-based show. Altogether, the company won three Emmy awards during the quarter.

In the third quarter, Netflix signed a number of partnership agreements with the likes of The Weinstein Company, PBS and DreamWorks Animation (DWA - Analyst Report) that will help the company venture into different genres like comedy, kid shows, political thrillers, autobiographies and horror.

International subscriber growth was helped by Netflix’s launch in the Nordic countries as well the Netherlands. The company also gained from steady growth in its existing markets.

Margins

Consolidated contribution profit margin (revenues minus cost of revenues plus marketing costs) improved 320 basis points (bps) from the year-ago quarter to 18.0%. However, contribution profit declined 10 bps on a sequential basis.

The strong year-over-year growth in contribution profit was primarily driven by 74.0% surge in domestic contribution profit, which fully offset an 18.4% decline in DVD contribution profit and a loss of $74.3 million loss in international streaming segment.  

The sequential decline was primarily due to higher loss in the international streaming segment. The segment’s results were negatively impacted by higher marketing expenses related to Netflix’s launch in the Netherlands and marketing campaigns in the Nordic countries and Brazil.

Marketing expense as percentage of revenues declined 150 bps from the year-ago quarter and 90 bps from the previous quarter. Similarly, technology & development expense as a percentage of revenues decreased 50 bps year over year and 10 bps on a sequential basis.

However, general & administrative expense as a percentage of revenues increased 30 bps from the year-ago quarter and 10 bps from the previous quarter.

Operating income was $57.1 million compared with $16.1 million in the year-ago quarter. The year-over-year surge was primarily driven by higher revenue base and lower expenses. However, operating income remained flat on a sequential basis.

Net income was $31.8 million or 52 cents (better than the management’s guidance of $26.0 million or 43 cents) compared with $7.7 million or 13 cents in the year-ago quarter and $29.5 million or 49 cents in the previous quarter.

Balance Sheet

At the end of the third quarter, Netflix had $1.13 billion in cash and cash equivalents (including short-term investments) compared with $1.08 billion in the previous quarter. Long-term debt stood at $500.0 million at the end of the quarter.

Netflix generated $34.7 million in cash flow from operations compared with $33.9 million at the end of the previous quarter. The company reported free cash flow of $7.0 million in the quarter.
 
Outlook

For the fourth quarter, management forecasts earnings between 47 cents and 73 cents. Net income is expected in the range of $29.0 million to $45.0 million.

Domestic and international streaming revenues are expected in the range of $731.0 million - $741.0 million and $210.0 million - $224.0 million, respectively.

Management expects total subscribers in the domestic and international streaming markets in the band of 32.7 million to 33.5 million and 10.1 million to 10.9 million, respectively.

Domestic streaming contribution profit is expected to be in the range of $165 million to $177.0 million. International streaming loss is expected to be in the range of $73.0 million to $57.00 million. DVD contribution profit is expected to be in the range of $96.0 million to $100.0 million.

Netflix intends to step up its spending on original content and also plans to launch in new international markets in 2014.

Our Take

Netflix reported an impressive third quarter and also provided an optimistic guidance. We believe that the expanding content portfolio and launch in new international markets will help it to counteract stiff competition from the likes of Amazon.com (AMZN - Analyst Report) and HBO.

Although, Netflix’s continuous subscriber loss in its DVD business and higher spending on content acquisition are concerns, the company’s growing subscriber base will continue to be a major growth factor in the near term.

Moreover, the company recently entered into partnerships with cable television providers Virgin Media (in UK) and Com Hem (in Sweden) to provide its service through set-top boxes from TiVo (TIVO - Analyst Report). It is also looking for cable partners in the domestic market, which we believe will further boost subscriber base, going forward.

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

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