We have been bullish on shares of Netflix (NFLX) for some time, arguing that the company's critics do not give the company enough credit for its strong competitive position and international (as well as domestic) growth prospects. The company's robust Q4 2012 results and guidance highlight the long-term potential that Netflix has, and we believe that over the course of 2013, the stock will continue to see gains.
In this article, we will review Netflix's Q4 2012 results and guidance, and delve into the company's international operations, competitive position, and its financials, all of which we believe have been underestimated by the company's critics. Unless otherwise noted, financial statistics and management commentary used in this article will be derived from Netflix's Q4 2012 shareholder letter.
Q4 Review: A Banner End to 2012
For the fourth quarter of 2012, Netflix posted EPS of $0.13 (flat year-over-year) on revenues of $945.239 million (up 4.44% year-over-year), both of which easily surpassed consensus estimates, which called for a loss of 13 cents per share, and revenues of $934.5 million. And while Netflix shed 380,000 DVD subscribers, it added 2.05 million domestic streaming subscribers, and 1.81 million international streaming subscribers. The company's profitability also expanded, with margins improving across all 3 of its reporting segments (as well as on a consolidated basis, which takes into account certain unallocated costs). We break down Netflix's divisional results below (figures are in millions).
Netflix Divisional Results
YOY Change in Revenue
YOY Change in Contribution Profit
YOY Change in Contribution Margin
Netflix's international operations are growing rapidly, with revenues rising more than 200% year-over-year, and 29.49% sequentially. Losses are narrowing as well, with the division losing 103.96% of revenue in Q4 2012, versus 117.95% in Q3 2012 and 206.9% a year ago. The company's domestic streaming operations are becoming more profitable, with contribution profits more than doubling year-over-year, reaching $109 million. Netflix CEO Reed Hastings stated in the Q4 shareholder letter that in Q1 2013, the contribution profits from streaming are set to exceed those from the DVD business for the first time ever. We should note that in Q1, Netflix is going to reallocate some overhead costs related to marketing from the streaming segment to its global business.
While this will boost contribution margins, it bears noting that up to this point, Netflix allocated all global marketing costs to the company's domestic streaming division, which has led to artificially depressed contribution margins, given that the company's marketing costs include other expenses beyond marketing its domestic streaming service. On a consolidated, global basis, Netflix's operating margin was 2.078% in Q4 2012, versus 1.783% in Q4 2011.
Netflix also issued robust guidance for Q1 2013, calling for EPS of $0.00-$0.23 ($0.11 at the midpoint), versus a consensus estimate of a loss of 7 cents per share. The company is also calling for 28.85 million domestic streaming subscribers at the midpoint of its Q1 guidance, implying 1.7 million net additions, in line with Q1 2012. This has long been a source of concern for Netflix investors, given the need to ramp up domestic subscriber levels in order to finance the company's transition away from DVDs and fuel its international growth, which we feel will become a much more material part of Netflix's future in the quarters to come.
International Markets: Streaming Forward
Netflix now has over 6 million international subscribers, and almost 5 million of those are paid subscribers (paid subscribers grew 32.52% sequentially, and 237.23% year-over-year). While Netflix's international losses are growing (due to the costs of launching its Nordic streaming services), they are shrinking as a proportion of revenue, on both a sequential and year-over-year basis (losses were 103.96% of revenues in Q4 2012, 117.95% of revenues in Q3 2012, and 206.9% in Q4 2012). The international division's loss of $105 million came in $8 million ahead of Netflix's own guidance, due to higher-than-expected revenues. CEO Reed Hastings stated that he expects losses to decline over the course of 2013, as paid subscriptions continue to outpace content costs, and called for a Q1 international loss of $87 million. Netflix will not launch in new international markets until "late 2013 or 2014," but did note that its launch in the Nordic region was "very successful."
The company is also making progress in Latin America, specifically with the issue of payments. While electronic payments are not an issue in Canada or Nordic countries, they have presented an obstacle to Netflix in Latin America, and are holding back growth in the region. In our last article on Netflix, we alluded to the fact that this issue will be solved in the long run, as Latin American economies continue to develop, and Netflix is making progress in 2 of the region's largest economies. In Mexico, subscribers can now pay for Netflix via debit cards, which must often be set up on a bank-by-bank basis. And in Brazil, Netflix is working on enabling payments via Boleto Bancario, a Brazilian payment network that blends together e-commerce and physical cash. A customer can pay a Boleto in any Brazilian post office, bank, or ATM, thereby allowing them to pay Internet merchants, such as Netflix, with cash, providing Netflix with a workaround of issues related to electronic payments in Latin America's largest economy.
We continue to believe that in time, electronic payments will become more prevalent in Latin America, eliminating this as an issue for Netflix. While it is true that Netflix's international operations are unprofitable, and will likely remain so for some time (aside from Canada), we believe that they will be profitable in the long run, as Netflix continues to improve its content offerings and offer international subscribers a better and better experience.
Domestic Streaming: Original Content & Competition
Netflix added over 2 million subscribers in Q4 2012, and is projecting to add 1.7 million in Q1 2013. Starting this quarter, Netflix will offer a more detailed breakdown of this division's costs, so that investors can see specific costs, such as cost of revenues and marketing. Netflix is continuing to invest in content, both original and third party, and its newest deal with Warner Brothers (TWX) gives Netflix exclusive access to catalog seasons of many Warner shows, including The Revolution and The Following. And, as Reed Hastings stated in the company's shareholder letter, this deal marks a milestone for Netflix: it is the first time that the company has licensed content directly from its producers, rather than the network on which the show in question airs. This mechanism allows Netflix to license shows earlier than it otherwise would.
Netflix is ramping up its investments in original content, with several series either returning or launching in 2013. On February 1, House of Cards premieres, and on April 19th, Hemlock Grove premieres. Lilyhammer returns for Season 2 this year, and Netflix is also reviving the show Arrested Development, with Season 4 set to launch in May. Are these shows meant to be profit centers, similar to what HBO is for Time Warner. At this point in time, we think this is unlikely to be Netflix's goal. Rather, it is about improving the streaming experience, and offering subscribers quality content that they cannot find anywhere else.
We turn now to the subject of competition, which has long been central to the bear thesis regarding Netflix. Simply put, we believe that Netflix's results should go a long way towards allaying these fears. Netflix is keeping its competitors (we hesitate to call many of them competitors due to different business models) at bay, and we believe that this will continue. Netflix examined the top 100 TV shows and top 100 movies that its subscribers watch, and found that of those 200 titles, no one has more than 100. Amazon (AMZN) holds 73, Hulu holds 27, and Redbox (CSTR) holds 12. Amazon is continuing to invest in its Prime streaming service, but we question how long the company will be able to invest at a torrid pace. The company is already posting operating losses, and is showing no signs of slowing down its investments in any of its segments.
Can Amazon continue to invest in Prime, the Kindle line, and its retail business at these levels indefinitely? We believe that sooner or later, something will have to give. In our view, fears regarding competition have been overblown, and Netflix has demonstrated for several quarters that competing streaming services are not having an effect on its business. But, with HBO GO looming over the horizon, will this continue? We believe that it will, due to a confluence of factors. It has long been rumored that HBO will launch a domestic standalone streaming service, just as it is preparing to do in Nordic markets. HBO's original content is seen by many as the standard to which the industry is held, and many investors and industry observers assume that a standalone HBO GO will be a threat to Netflix.
We, however, do not see it this way. Netflix's value proposition is that you can access a wide and growing array of content anywhere you go, and on a variety of platforms, ranging from TV's to iPhones and iPads. HBO's value proposition is the unmatched quality of its original content, content that subscribers are willing to pay a premium for (it is no accident that Time Warner's Networks division is its most profitable segment, with an operating margin of 36.63%, versus 23.12% for Time Warner as a whole). At the present, HBO GO is not meant to be a revenue generator, but rather a way to retain and add new subscribers to HBO, for HBO GO allows them to access HBO's content on-demand. Given that HBO content is unavailable for streaming on Netflix, we question the competitive effects that HBO GO will have.
The excitement surrounding a standalone HBO GO stems from a consumer desire to access HBO content without needing to subscribe to cable, not a desire for an entirely new streaming service analogous to Netflix. And given that HBO is Time Warner's most profitable business, we believe that the company will proceed slowly and delicately with any rollout of a standalone HBO GO here in the United States, in order to mitigate the impact to its margins as best it can, thereby buying Netflix time to fortify itself against any possible competitive threat.
Financials: What About the Cash Flow?
Critics of Netflix will likely jump at the fact that even though Netflix posted net income of $7.897 million in Q4 2012, it burned $16.186 million in operating cash flow, and posted free cash flow of negative $51 million. However, there is more to these figures than meets the eye, for a number of factors have served to depress cash flow. Several changes in working capital depressed cash flow this quarter, including accelerated payments of accrued expenses (a drag of $14.125 million), payments for prepaid content related to Netflix's original programming (a drag of $26.777 million), and investments in the rollout of Netflix's new Open Connect content delivery system. Taxes also played a role, with Netflix's tax provisions rising by 64.06% year-over-year to $7.007 million.
CEO Reed Hastings addressed the issue of cash flow, stating that another reason for negative free cash flow was a temporary increase in the cost of content due to original programming. Historically, Netflix manages its content licensing deals so that the physical cash payments the company makes each quarter do not exceed 110% of its income statement expense. However, in quarters with significant investments in original content, such as Q4 2012, the ratio may rise to 120%. CEO Reed Hastings states that while free cash flow will fall further in Q1 as the company makes the majority of original content payments, it will rebound "substantially" over the remainder of 2013.
In any case, Netflix's finances are in decent shape; the company ended Q4 2012 with $748.078 million in cash & investments, and $400 million in debt ($200 million of which is in the form of convertible notes). Netflix's debt is due in 2 tranches: $200 million in November 2017, and the remaining $200 million in December 2018. According to CEO Reed Hastings, the company may refinance this debt in 2013 in order to take advantage of lowered interest rates (the $200 million in non-convertible debt on Netflix's balance sheet carries an interest rate of 8.5%). The company may also issue new debt, in order to have more cash on hand, as well as the "flexibility" to invest in new original content (and presumably new licensing deals as well, although the company did not cite this as a reason for a potential debt offering). Netflix's debt is not due for at least 4 years, by which point we believe the company's financial position will be stronger than where it is today (as a side note, we reviewed Netflix's streaming costs in detail in our last article on the company).
In our view, Netflix's best days are ahead of it. The company is cementing its leading position in the U.S. streaming market, and its international expansion is on track, and is showing strong growth in both revenue and subscribers. Netflix's financial and competitive positions are stronger than what the company's critics will admit. The company is keeping other streaming services at bay, and is working hard to continuously improve the subscriber experience, in order to retain and add more subscribers. Since our last article on Netflix, published on December 18, the stock has rallied 9.03%, as of the close of trading on January 23, versus a 4.5% advance for the S&P 500 (SPY).
But that does not take into account Netflix's post-earnings surge, which has sent the stock up over 35% to almost $140. Do we think that Netflix is a buy at these levels? It is difficult to make such a claim. That being said, we believe that investors should add to or initiate positions in Netflix on a pullback. The company's Q4 2012 results show that it is executing on all fronts, both here in the United States and around the world. We believe that in the quarters and years to come, Netflix will not only deliver more content to more subscribers, but that it will deliver meaningful returns to its investors as well.