Netflix (NFLX) reported strong Q1 2013 earnings results yesterday, with an EPS of $0.31 that beat consensus by 13 cents and a revenue of $1.02 billion that was in line with estimates. Underlying metrics showed excellent Q1 performance in all three segments of its business. In this article, I will present a summary of Netflix's earnings results, discuss the positive and negative points from the investor letter and the earnings call, and will comment on Netflix management likening the company's original content strategy to the Harry Potter series.
Summary of Results
Netflix reported that it added 2.03 million domestic streaming subscribers during the quarter, bringing total domestic streaming members to 29.17 million vs. guidance of 28.5-29.2 million. Segment revenue of $639 million was also on the higher side of the company's Q1 guidance of $633-641 million. However, the most impressive metric was the domestic streaming contribution margin of $131 million, beating the company's guidance of $122-130 million.
Netflix added 1.03 million International Streaming members during Q1, taking its total subscribers to 7.14 million vs. management guidance of 6.6-7.3 million. The contribution loss for this segment stood at $77 million during the quarter, which was a smaller loss than management's forecast of $80-94 million contribution loss. The lower than expected loss was primarily due to less than forecast growth in international content spending and Netflix does not expect a significant improvement to the contribution loss for this segment in Q2.
Netflix was able to deliver stronger than expected results for its DVD segment as well; the DVD members showed a modest decline to 7.98 million vs. management guidance of 7.6-8.05 million, which is again at the higher side of management guidance. The segment's contribution profit of $113 million was better than management guidance of $101-112 million, thanks to strong revenues and lower than expected content costs.
Clarification on The Original Content Strategy
In the Original Series segment of Netflix's Investor Letter, the management made a very interesting comment:
"Harry Potter was not a phenomenon in book one, compared to later books in the series."
This is a very apt way to describe Netflix's original series strategy and answer most of the frequently asked questions related to it. Netflix does not see House of Cards or Arrested Development as a way to provide a quick boost to its subscriber numbers. Similar to the Harry Potter series, Netflix is looking to build initial excitement around the first seasons of its original programming. If the members like the first season of the series, they would be eagerly and actively waiting for the next season, and the anticipation keeps getting stronger with each season, making the members glued to the Netflix service. The analogy with Harry Potter books also makes sense in another way: in both cases, many hours' worth of content is made available to be consumed at the same time, leaving it up to the content consumer to decide in what time he or she wants to consume it. For many Harry Potter fans, the excitement around a new book release was such that after the release of the latest book of the series, fans would read the entire novel in a single day. Similarly, Netflix also gives it members the option to binge-watch an entire original series in one go, in stark contrast to one episode a week routine on traditional TV. In the comparison with Harry Potter, I think that Netflix has got the right idea and a highly ambitious target; however, it remains questionable if Netflix can achieve the heights scaled by the Harry Potter series.
In addition to the better than expected earnings results, here are some of the positives that I noticed in the earnings results:
- Netflix reported a 140 bps sequential improvement in Domestic Streaming contribution margin from Q4 which beat the company's ambitious target of an average of 100 bps improvement in contribution margin each quarter. In fact, Netflix has improved its Domestic Streaming contribution margin by 6% Y/Y on a flat marketing expense. This shows that while competitors like Amazon (AMZN) are focusing on revenue growth at the expense of margins, Netflix continues to grow subscribers and revenues at a faster pace than content spending, thereby delivering growth in both revenue as well as profitability.
- Early signs show that Netflix's strategic tilt towards original content seems to be working. I was one of the doubters who thought that a lot of people would subscribe for a free trial just for House of Cards, and then cancel. However, Netflix reported that out of millions of new subscribers, only 8000 cancelled which shows that the new subscribers are attracted to the service. Netflix also reported that Hemlock Grove was viewed by more members globally in its first weekend than was House of Cards, which also shows the popularity of original content and removes doubts that only hyped up content like House of Cards and Arrested Development would appeal to members.
- I had mentioned in my earnings preview that Q2 guidance would be important. Although Netflix had warned earlier that net subscriber additions during Q2 2013 would probably be lower than the additions in Q2 2012 due to the impact of seasonality on a larger subscriber base, the mid-point of management's guidance forecasts Domestic Streaming net additions of 0.55 million, which is slightly above the Q2 2012 net additions of 0.53 million. Netflix management attributed this better than expected guidance to strong improvements in its service over the past year which has contributed to higher user satisfaction, as well as to the highly anticipated fourth season of Arrested Development which premieres on May 26th exclusively on Netflix.
- Q1 results also showed that Netflix's highly profitable DVD business continues to decline, but at a slow pace, alleviating concerns that a sharp decline in this segment could damage Netflix in the short term while it continues to ramp up its Domestic and International Streaming businesses. Investors would be happy with a contribution margin of 46.6% for this segment. Netflix also told us that it would continue to be able to maintain contribution margin during the first half of the year for the full year 2013 which is also very positive. In response to a question on the earnings call, CFO David Wells reiterated that he was confident that Netflix's ability to maintain strong contribution margins in DVD despite declining subscribers thanks to relatively fixed investments.
While the overall results were generally positive, here are some of the points that should dampen the investors' initial excitement at the earnings results:
- In response to a question about third-party content negotiations, CEO Reed Hastings mentioned that Netflix's competitors such as Amazon and Hulu are bidding more aggressively for the same content, which has made the content acquisition costs for Netflix higher than they would otherwise be. This shows that Netflix not only faces competition for subscribers, it also faces competition for content; the increased leverage of content providers over Netflix is not a positive development and could hamper the company's contribution margins in the future.
- Netflix management is still not coming clear about its cash flow situation; at least not as clear as I would like them to be. In the Q4 2012 investor letter, the management noted: "The bulk of our remaining cash payments for our current originals will be in Q1, driving FCF materially more negative than Q4, and then FCF will improve substantially in subsequent quarters." That is why I was looking for some positive comments from the management this time round, but I was disappointed with the following remarks in the investor letter: "The investments that will continue to weigh on our cash flow relative to net income are Originals and non-Originals content (ongoing) and our Open Connect conversion (primarily in 2013)." There appears to be no sign of improvement on the free cash flow front in the near term. This is especially worrying because Netflix has $3.3 billion in off-balance sheet content liabilities and only $1 billion in cash.
Q1 results show that Netflix has continued to maintain its strong momentum in subscriber growth from Q4 2012, which is seen as the primary driver of stock performance, at least in the near term. Netflix also reiterated its strategic shift towards original programming after seeing positive signs from House of Cards. Moreover, the company gave an indication of its long term plans about original content by comparing its original series strategy with the Harry Potter series. However, increased competition for content especially with Amazon, no clarification on the timing of positive free cash flow, and rising off-balance sheet liabilities, combined with the expensive P/E multiple, make Netflix a risky buy.