Netflix Grows but Misses

Shares of Netflix Inc. (NFLX - Analyst Report) were down $10.95 after hours as second quarter 2010 revenues missed Street expectations. Although Netflix reported a revenue growth of 27.0% year over year to $519.8 million, it fell short of analysts’ expectations of $524.1 million. Revenue came in at the low-end of management’s guidance range of $517.0 million to $525.0 million.
 
Earnings
 
Despite missing street revenue expectations, net income including stock-based compensation and its tax effect increased 34.1% year over year to $43.5 million from $32.4 million. Earnings per share, including stock-based compensation and its tax effect increased 35.6% year over year to 80 cents from 59 cents. Earnings per share beat the Zacks Consensus Estimate of 70 cents by ten cents.
 
Revenues and earnings were primarily driven by a strong year-over-year growth in the total subscriber base driven by an increasing streaming content from Netflix.
 
Gross margin was 39.4% compared with 34.1% in the second quarter of 2009 and 37.8% in the first quarter of 2010. Management pointed out that it’s the largest year-over-year improvement in the last four years mainly attributable to growth in Disc shipments. However the Disc shipment growth was below management’s expectation.
 
Subscriber Base
 
Netflix exited the second quarter of 2010, with approximately 15.0 million total subscribers, up 42.0% year over year. This was at par with management’s guided range. Paid subscribers accounted for 97% of total subscribers, which declined from 98.0% reported in the prior-year quarter.
 
Net subscribers increased 1.0 million in the quarter versus 0.3 million in the second quarter of 2009 and 1.7 million in the first quarter of 2010. Gross subscriber addition escalated 58.0% year over year and 12.0% quarter over quarter to 3.1 million in the quarter.
 
Subscribers who watched instantly more than 15 minutes of a TV episode or a movie in the second quarter of 2010 were 61% compared with 37% in the second quarter of 2009 and 55.0% in the first quarter of 2010.
 
Subscriber acquisition cost in the second quarter of 2010 was $24.37 per gross subscriber addition compared with $23.88 in the second quarter of 2009 and $21.54 in the first quarter of 2010.
 
Churn in the second quarter of 2010 was 4.0% compared with 4.5% in the second quarter of 2009 and 3.8% in the first quarter of 2010.
 
New Services
 
Netflix remains focused on Internet streaming as it continues to upgrade its digital delivery, thereby broadening its subscriber base.
 
Netflix announced the expansion of its movie subscription services over the Internet to Canada. The Canadian subscribers will be able to access this service by late 2010. Canada will be the first country outside the United States to receive Netflix services. However, Netflix’s another popular service through which DVD’S are delivered via e-mail will not be available for the Canadian subscribers.
 
Additionally, Netflix recently signed an agreement with Relativity Media. Netflix has also started streaming videos through Nintendo's Wii video game console. We believe this will likely boost Netflix's subscriber base as approximately 24 million Wii owners in the U.S. can access Netflix’s services. The company has also gained massive popularity from its availability on Apple Inc.’s (AAPL - Analyst Report) iPad. These partnerships will provide a long-term boost to the company’s earnings in our view.
 
Balance Sheet
 
As of June 30, 2010, cash and cash equivalents were $107.3 million versus $79.9 million at the end of March 31, 2010. Cash flow from operating activities was $60.3 million versus $77.2 million in the first quarter of 2010. Free cash flow was $34.2 million versus $37.6 million in the first quarter of 2010.
 
Netflix repurchased 0.4 million shares at an average cost of $108.24 per share in the second quarter.
 
Outlook
 
The company provided its guidance for both the third and fourth quarters and raised the same for full year 2010. For the third quarter of 2010, management forecasts revenues to range from $546.0 million to $554.0 million and expects total subscribers in the range of 16.3 million to 16.7 million. Netflix expects GAAP net income to range from $33.0 million to $40.0 million and earnings in the range of 61 cents to 74 cents per share.
 
For the fourth quarter of 2010, Netflix expects revenues to range from $580.0 million to $596.0 million and expects total subscribers of 17.7 million to 18.5 million. Netflix expects GAAP net income to range from $32.0 million to $40.0 million and earnings in the range of 58 cents to 73 cents per share.
 
For the full year 2010, Netflix forecasts revenues to range from $2.14 billion to $2.16 billion (previous guidance $2.11 billion to $2.16 billion) on a total subscriber base of 17.7 million to 18.5 million. Netflix projects GAAP net income to be in the range $141.0 million to $156.0 million (previous guidance $132.0 million to $144.0 million) and earnings in the range of $2.58 to $2.86 per diluted share (previous guidance of $2.41 to $2.63 per diluted share).
 
Maintained Outperform
 
Netflix continues to invest aggressively on its streaming portfolio and has several deals in the pipeline. Netflix expects gross margin to drop from the second quarter level once these deals are confirmed due to a higher streaming content expense. However, Netflix believes its aggressive streaming strategy will improve subscriber growth, lower churn, lower subscription acquisition cost, and will increase operating profit and ensure better cash flow.
 
We have a short term (for the next 1 to 3 months) ‘Buy’ rating on Netflix, supported by the Zacks #2 Rank. We believe that Netflix’s focus on improving its subscriber base by offering its services through high speed Internet and an upgraded content delivery will increase its profitability going forward. However, it faces stiff competition from Movie Gallery Inc., Hulu Plus and Coinstar (CSTR - Snapshot Report).

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