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Netflix (NFLX - Analyst Report) reported a strong first-quarter 2014. The streaming service provider reported earnings of 86 cents per share that surpassed the Zacks Consensus Estimate by 3 cents.

Revenues of $1.27 billion were in line with the Zacks Consensus Estimate in the quarter. Most significantly, the company added 4.00 million streaming subscribers (domestic + international), much better than management’s guidance of 3.85 million.

As anticipated, Netflix is planning to raise streaming prices by a modest $1.0–$2.0 for new subscribers in selected regions beginning late second-quarter 2014. However, this did not impact the share price as Netflix increased 6.8% ($23.71) in after-hours trading.

Despite a recent successful price increase in Ireland, which had limited negative impact on subscriber growth, management’s cautious price increase plan suggests that it does not want to repeat the 2011 debacle.

In Jul 2011, Netflix raised the prices of its combined streaming and DVD-rental package by 60% that enraged customers, resulting in substantial subscriber loss. The company’s decision to split the DVD business into a separate entity also did not go down well with investors. Netflix’s share price plummeted from a high of $300.0 in July to a low of $60.0 by the end of 2011.

However, we believe the current price increase will not hurt Netflix’s growth prospects due to superior content portfolio, selective nature of the plan and measured approach. The price hike will not affect existing customers, at least for the time being, which is expected to work in favor of the company.

Netflix’s focus on improving customer engagement will also play a significant role in limiting any churn rate due to this price increase. In February this year, the company agreed to pay an annual fee to Comcast (CMCSK) in order to ensure better streaming quality, following customer complaints.

The company also criticized Comcast and other Internet Service Providers (ISPs) for extracting fees from content producers as well as intermediate distributors such as Akamai (AKAM - Analyst Report) for delivering data and services. Verizon’s legal victory over Federal Communications Commission (FCC) at the U.S. Court of Appeals on the “net neutrality” regulation paved the way for these ISPs to charge extra fees.

Netflix argued for “strong net neutrality” rules, which will ensure smooth content transmission to end users at no extra cost. The company also voiced strong opposition to Comcast’s planned $45.0 billion acquisition of Time Warner Cable.
 
Quarter Details - Revenues

Revenues jumped 24.0% from the year-ago quarter, primarily driven by higher international revenues (21.0% of revenues), which soared 88.1% year over year and 20.6% quarter over quarter.

Domestic revenues (63.0% of revenues) surged 25.0% from the year-ago quarter and 7.8% from the previous quarter. However, DVD revenues decreased 16.0% year over year and 4.2% on a sequential basis.

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 11.89 million paid streaming subscribers over the last 12 months. On a sequential basis, Netflix added 4.70 million paid subscribers in the first quarter.

Total streaming subscriber base increased 12.04 million year over year to 48.36 million. Sequentially, total subscriber growth was 4.00 million. This strong subscriber addition was primarily driven by Netflix’s expanding content portfolio that includes original productions such as House of Cards.

During the quarter, Netflix announced its first original live-action comedy series, Grace and Frankie, featuring Jane Fonda and Lily Tomlin.

Margins

Consolidated contribution profit margin (revenues minus cost of revenues and marketing costs) improved 440 basis points (bps) from the year-ago quarter and 150 bps on a sequential basis to 20.8%.

The strong year-over-year growth in contribution profit was primarily driven by 53.2% surge in domestic contribution profit, which fully offset a 14.1% decline in DVD contribution profit and loss in international streaming segment.  

The sequential increase was primarily due to 15.9% increase in the domestic streaming business. Despite heightened marketing activities international streaming segment reported much lower loss.

Marketing expense as a percentage of revenues declined 80 bps from both the year-ago quarter and previous quarter. Technology & development expense as a percentage of revenues decreased 30 bps on year-over-year basis but increased 40 bps on a sequential basis.

General & administrative expense as a percentage of revenues increased 10 bps from the year-ago quarter and 50 bps from the previous quarter.

As a result of improving cost structure and higher revenue base, operating income jumped to $97.6 million from $31.8 million in the year-ago quarter. Operating income also increased 18.6% from the previous quarter.

Net income was $53.1 million or 86 cents (better than management’s guidance of $48.0 million/78 cents) compared with $18.6 million or 31 cents in the year-ago quarter and $48.4 million or 79 cents in the previous quarter.

Balance Sheet

At the end of the first quarter, Netflix had $1.67 billion in cash and cash equivalents (including short-term investments) compared with $1.20 billion in the previous quarter. Long-term debt stood at $900.0 million at the end of the quarter.

Netflix generated $36.4 million in cash flow from operations compared with $41.4 million at the end of the previous quarter. The company reported free cash flow of $8.4 million in the quarter.
 
Outlook

For the second quarter, management forecasts earnings of $1.12 and net income of $69.0 million. The earnings guidance is higher than the current Zacks Consensus Estimate of $1.01 and 49 cents per share reported in the year-ago first quarter.

Domestic and international streaming revenues are expected to be $835.0 million and $304.0 million, respectively. Total streaming revenues are expected to be $1.14 billion.

Management expects to add 0.52 million subscribers in the domestic streaming segment and 0.94 million in the international segment in the second quarter of 2014. Netflix expects total subscribers of 49.81 million at the end of second quarter.

Domestic streaming contribution profit is expected to be $223.0 million. International streaming loss is expected to be $12.0 million.

Netflix forecasts operating income of $125.0 million for the second quarter. The company intends to step up its spending on original content and also plans to foray in new international markets in the second half of 2014.

Our Take

The recent momentum stock sell-off that started from late March significantly affected Netflix’s share price, which declined 14.2% over the last one month. We believe that the company’s strong first-quarter results, streaming subscriber growth and positive guidance will help the stock to regain some momentum in the near term.

However, rising content costs, net neutrality related concerns and intensifying competition are major headwinds. Netflix has $7.25 billion due for content streaming obligations, out of which $2.97 billion needs to be paid within the next 12 months. After that period, Netflix needs to pay $3.27 billion within the next three years.

Although the company is lobbying for “strong net neutrality” rules, we believe that it will have no significant effect on big ISPs such as Comcast, Verizon and AT&T, at least in the near term. Netflix recently expressed its concerns about AT&T’s slow fiber-based U-verse, which has lower performance than many DSL ISPs.

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.

Instead they might try to follow the Comcast model, which may force Netflix to enter into similar fee paying arrangements to ensure better streaming quality. Moreover, if the Comcast-Time Warner deal gets approval, Netflix may face significant pressure from the combined entity to increase its annual fees, which will further dent cash balances.

Although Netflix’s measured approach regarding price increase is appreciative, we believe that the cautious step may not be enough to offset the rising operating costs. However, too much aggressiveness may hurt subscriber growth, particularly in international markets amid intensifying competition from the likes of Amazon (AMZN - Analyst Report) Prime and HBO.

Nevertheless, we believe Netflix’s expanding content portfolio, innovative content pipeline for the second half of 2014 and expansion into new international markets are the major positives that will continue to boost its subscriber base.

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

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