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Netflix Inc. (NFLX - Analyst Report) reported third quarter 2012 earnings of 13 cents per share that surpassed the Zacks Consensus Estimate of 5 cents. Reported earnings were at the higher end of management’s guided range of (10 cents) to 14 cents. However, earnings plummeted from $1.16 per share from the previous-year quarter due to higher costs and margin contractions.

Quarter Details

Total revenue increased 10.1% year over year to $905.1 million and was in line with the Zacks Consensus Estimate. The year-on-year revenue growth was primarily boosted by newer additions in the total subscriber base.

At the end of third quarter 2012, total number of unique subscribers was 31.8 million, up from 25.3 million unique subscribers in the prior-year quarter. Moreover, paid unique subscriber base expanded to 29.9 million from 23.8 million the year-ago quarter. However, the company’s DVD business continued to lose subscribers in the quarter.

Domestic revenue (streaming and DVD) increased 3.5% from the year-ago quarter to $827.3 million, while Netflix’s International streaming business generated revenues of $77.7 million, significantly higher than $22.7 million in the previous-year quarter. Netflix’s international streaming revenue was at the higher end of management’s guided range of $72 million-$79 million.

Gross profit decreased 15.0% from the year-ago quarter to $242.5 million. Gross margin decreased from 34.7% in the year-ago quarter to 26.7% primarily due to the 27.6% year-on-year jump in subscriber costs.

Operating expenses increased 20.1% year over year to $226.3 million, due to higher marketing expenses (up 27.1% year over year), technology and development expense (up 18.8% year over year). General and administrative expense increased 2.6% year over year during the quarter.

Operating profit for the quarter was $16.1 million, down from an operating profit of $96.8 million in the previous-year quarter. Operating margin for the quarter was down from 11.8% in the previous-year quarter to 1.8% due to higher operating costs.

Net income for the quarter was $7.7 million down from $62.5 million earned in the previous-year quarter. Net margin was 0.8% in the reported quarter versus 7.6% in the previous-year quarter. Decline in contribution profits in the DVD business and loss from the international business dragged the net margin down.

Exiting third quarter 2012, Netflix had $798.4 million in cash and cash equivalents (including short-term investments) compared with $813.3 million in the previous quarter. Long-term debt remained at $200.0 million at the end of third quarter 2012.

Cash flow from operating activities was $150K in the third quarter of 2012, while Netflix reported a negative free cash flow of $20.5 million for the quarter.

Quarter Ahead

For the forthcoming quarter, management forecasts the loss/earnings per share to be between (23 cents) to 4 cents. The Zacks Consensus Estimate is pegged at a loss of 8 cents per share. Net income is expected to be in the range of ($13.0 million) to $2.0 million.

Domestic and International streaming revenue is expected to be in the range of $581.0 million-$588.0 million and $90.0 million-$100.0 million, respectively. Domestic DVD revenue is expected to be in the range of $248.0 million to $255.0 million for the fourth quarter of 2012.

Management expects total subscribers in the domestic streaming market and in the international streaming market to range from 26.4 million to 27.1 million and 5.2 million to 5.9 million, respectively. The U.S. DVD subscriber base is expected to be in the range of 7.85 million to 8.15 million.

Management expects contribution losses from the international business to increase primarily due to escalation of costs related to content additions and incremental marketing expenses. Incidentally, the company has recently expanded to the Nordics (Denmark, Finland, Norway and Sweden). Management also hinted Netflix to report consolidated loss in the fourth quarter on account of higher expenses related to the launch in Nordic countries.

Recommendation

Although Netflix reported better-than-expected third quarter results, we believe that earnings growth will take some time to rebound. Higher capital expenditure due to international expansion will hurt earnings growth in the near term.

Moreover, investments to improve online content offerings would also weigh on the margins going forward. Also, increasing competition from Amazon.com Inc. (AMZN - Analyst Report) will remain an overhang on the stock going forward.

However, Netflix’s new and exclusive content offerings to its subscribers are the company’s biggest USP compared to some of its closest peers. Apart from recent movies and documentaries, Netflix is also boosting its original content portfolio to entice new subscribers in the US and International markets.

With its own content delivery network, Open Connect, Netflix’s video library will be directly connected to Internet service providers, ensuring smooth and fast data transfer that would eventually enrich the customer experience.

We have a Neutral recommendation on Netflix over the long term. Currently, Netflix has a Zacks #3 Rank, which implies a Hold rating over the short term.

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