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Netflix Inc. (NFLX - Free Report) reported third quarter 2011 diluted earnings of $1.16 per share, surpassing the Zacks Consensus Estimate of 96 cents per share and increasing 65.7% from the prior-year quarter. Earnings surpassed management’s guidance range of 72 cents to $1.07.

Total revenue of $821.8 million not only increased 48.6% from the year-ago quarter, but also beat the Zacks Consensus Estimate of $813.0 million. The total revenue was in the higher end of management’s guidance range of $799.5 million to $828.5 million.

Despite the company beating the estimates on both top-line and bottom-line, shares plummeted 27.8% to $85.75 in after-hours trading as subscriber exodus was more than the company’s projections. Additionally, acknowledgement of a weak upcoming fourth quarter 2011 weighed down the stock.

Quarter Evaluation

Domestic revenue increased 44.5% from the year-ago quarter to $799.2 million and international operations revenue of $22.7 million was at the higher end of management’s guidance range of $19.5 million to $23.5 million.

The year-on-year growth in revenues was primarily boosted by newer additions in the total subscriber base. At the end of third quarter 2011, the total number of subscribers (Domestic and International) was 25.3 million, an increase of 49.3% from the prior-year quarter.

However, on a sequential basis, Netflix lost 0.3 million total subscribers (both domestic and international).  Netflix’s domestic subscriber base shrunk approximately 800k during the third quarter, which was more than the company’s prediction of a 600K decline that was perceived as an after effect of the rise in the subscription price.

Free subscribers, as a percentage of ending subscribers, decreased to 4.0% from the prior quarter’s 5.4% and 5.6% reported in the year-ago quarter.

Average monthly revenue per paying subscriber was $11.56 in the quarter, compared with $11.49 in the preceding quarter and $12.12 in the prior-year quarter.

Churn was 6.3% at the end of the quarter, up 210 basis points (bps) sequentially but down 250 bps year over year.

Gross profit increased 36.6% from the prior-year quarter to $285.2 million, but was down 4.5% on a sequential basis. Gross margin decreased 300 bps year on year and 320 bps sequentially to 34.7% on higher subscriber acquisition costs.

Operating profit increased 39.3% from the year-ago quarter to $96.8 million, but it was down 15.9% sequentially. Operating margin was down 80 bps from the year-ago quarter to 11.8% and 280 bps sequentially due to increased spending for streaming content and higher licensing fees.

Net income was $62.5 million, up 64.9% for the previous-year quarter, but was down 8.4% sequentially. Net margin was up 70 bps to 7.6% from the year-ago quarter, but down 100bps from the previous quarter.  

Balance Sheet and Cash Flow

Netflix exited the quarter with $365.8 million in cash and cash equivalents (including short-term investments) compared with $376.4 million in the previous quarter. Long-term debt was $200.0 million at the end of September 30, 2011, and remained flat sequentially.

Cash flow from operating activities was $49.5 million in the third quarter of 2011, compared with $86.4 million in the second quarter of 2011 and $42.2 million in the prior-year quarter. Free cash flow was down to $13.8 million sequentially from $59.5 million.

Quarter Ahead

For the forthcoming quarter, management expects EPS to be in the range of 36 cents to 70 cents, below the Zacks Consensus Estimate of $1.10 per share. Net income is expected to be in the range of $19.0 million to $37.0 million.

Domestic and International revenue is expected to be in the range of $816.0 to $845.0 million and $25.0 million to $30.0 million, respectively. The Zacks Consensus Estimate projects the revenues for the fourth quarter to be $929.0 million.

Management expects subscribers in the consolidated domestic market and in the international market to range from 30.3 million to 32.8 million and 1.6 million to 2.0 million, respectively.

For the fourth quarter, Netflix expects subscriber mix of US streaming subscribers to be between 20.0 million and 21.5 million. The U.S. DVD subscriber base is expected to be in the range of 10.3 million to 11.3 million.

Management expects the subscriber base to shrink due to weak DVD shipments and negative streaming net subscriber additions in the upcoming quarter. DVD shipments are expected to decline due to the price increase in the third quarter. Netflix expects to remain profitable on a global basis for the fourth quarter, primarily due to new content additions, which will have a positive impact on the existing subscribers domestically and add more new subscribers to its international ventures.

Netflix continues to pursue international expansion and has announced to foray into the UK and Ireland by early 2012. For these ventures, Netflix expects its margins to be subdued due to the brand-building initiatives and other costs in the forthcoming first quarter of 2012.

Conclusion

Although Netflix reported year-over-year growth in the third quarter, shares continued its bearish run, declining approximately 58.0% in the last 3 months, while S&P declined 6.2% during the same period. We expect the shares to remain range bound over the next 3-6 months.

However, Netflix’s partnerships with Hollywood studios leads to diversified content and a huge video library, which, enables the company to retain a favorable position compared to its peers. We believe that content additions will enable Netflix to reduce its dependence on cable TV operators and provide it with the necessary competitive edge over its peers in the emerging market of online video streaming. Moreover, strategic partnerships will also be beneficial, helping it to expand its geographical footprint

Netflix’s international expansions will also lead to significant growth over the long term. Netflix’s plan to expand in UK is fueled by the fact that it presents the company with a very high level of internet penetrated market (approximately 77.0% of the total house hold) have access to broadband internet or video game console. Additionally, the number person using debit and credit cards is also high in comparison to Latin America.

Nonetheless, with Netflix concentrating on overseas ventures and content additions, cost escalation in the form of license and renewal fees, as well as necessary technology investments would be a headwind going forward. This would pressurize margins and reduce profits.

Moreover, intensifying competition from large players such as Amazon.com Inc. (AMZN - Free Report) , Apple Inc. (AAPL - Free Report) and Google Inc. in the online streaming market is a headwind, as it will further push up license fees and also affect subscriber additions.

We have a Neutral rating on Netflix shares over the long term. However, a disappointing outlook and increasing churn rate are the primary headwinds in the near term. We currently have a Zacks #4 Rank for Netflix Inc., which translates into a Sell rating in the short term.




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