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Netflix, Inc. (NASDAQ:NFLX) this week announced its Q1 2011 results. The critical point here is that it is impressive growth, but not necessary great results since the stock was down over 5% in after hours trading. NFLX closed at $251.67 per share but lost about 5.3% in after hours trading after its earnings announcement. NFLX's shareholder letter and Q1 Financials are available at its website.

Strong Domestic Growth Continues

Most news coverage highlighted the growth aspects, which included the net addition of about 3.6 million subscribers, divided into 3.3 million domestic and 0.3 million international. Overall revenue growth continues to be impressive with another quarter of sequentially higher growth rates:

NFLX Revenue Growth

Date Revenue Quarterly Revenue Growth (Y/Y)
12/31/2008 $ 359.6 18.9%
3/31/2009 $ 394.1 20.8%
6/30/2009 $ 408.5 21.0%
9/30/2009 $ 423.1 24.0%
12/31/2009 $ 444.5 23.6%
3/31/2010 $ 493.7 25.3%
6/30/2010 $ 519.8 27.2%
9/30/2010 $ 553.2 30.7%
12/31/2011 $ 595.9 34.1%
3/31/2011 $ 718.6 45.5%

Source: NFLX financials

However, this is still similar to my earlier prediction in a previous article; my estimates were slightly below actuals, but I projected that growth would continue throughout 2011. I had Q1 2012 as the first quarter where year-on-year revenue growth would not be higher than the previous quarter's. Logic dictates that the trend of increasing (not just growth) cannot continue indefinitely.

Revenue surpassed analyst estimates and also showed an uptick in revenue per subscriber, as noted below:

Average Monthly Subscriber Revenue

Quarter End of Period Subscribers Average Subscribers Beginning of Period Subscribers Revenue Average Monthly Revenue
Q3 2010 16,933 15,967 15,001 553,219 $11.55
Q4 2010 20,010 18,472 16,933 595,922 $10.75
Q1 2011 23,600 21,805 20,010 718,553 $10.98

Source: NFLX financials; my determination of "average subscribers" is just a straight average of end-of-period subscribers and beginning-of-period subscribers. This also does not adjust for free subscribers. Subscribers are in thousands and revenue is in thousands of dollars.

Even adjusting for just domestic performance would show an uptick in average monthly revenue, but both figures are below the Q3 2010 result.

International Segment Performance creates Growth Concerns

However, the key challenge for NFLX is maintaining the view that it has compelling growth. NFLX broke out its financials for the international segment in more detail this quarter than previously. (I kept the financial spreadsheet from earlier this year for the 2010 year-end results, and there were some new line items on this quarter's disclosure.) This additional information provides some insights into what is happening in the international part of the business.

First, I've included a table showing subscriber changes. A key note for NFLX's business model is that the change in subscribers reflects a net change. NFLX usually has to add substantially more subscribers to offset cancellations.

International Subscriber Figures (click to enlarge)

Source: NFLX 2011 Q1 Financial Data. I assumed that the ratio of Lost Subscribers to Gross New Additions was the same in Q1 2011 as Q4 2011. Again, average subscribers just assumes the average between the end-of-period subs and the beginning-of-period subs. NFLX may have more precise data here that will appear in the 10-Q filing, which was not yet available at the SEC's website.

The first question mark is that the net additions declined in Q1 compared to Q4. The counter is that the Q4 performance in terms of lost subscribers was quite good. During NFLX's earlier days in the U.S., it would not be unusual for 60-70% which implied NFLX would have to acquire around three subscribers for each net addition since two others were canceling. Revenue per subscriber is also showing growth; however, this data is probably distorted due to free international subscribers, which are not detailed. International monthly revenue still trails domestic monthly revenue, but again this is probably due to free international subscribers.

Average Monthly International Subscriber Revenue

Quarter Average Subscribers (000) Revenue ($000) Monthly Revenue Per Subscriber
Q3 2010 67 $ 1 $ 0.01
Q4 2010 321 $ 3,617 $ 3.76
Q1 2011 656 $ 12,279 $ 6.24

Source: NFLX Financials, my estimate of average international subscribers.

Another key factor is acquisition cost. Domestic acquisition cost per new subscriber increased from $10.87 to $14.38 for domestic subscribers from Q4 to Q1. This was after a substantial decline from Q3 to Q4. The international picture looks even worse:

International Subscriber Acquisition Costs

Quarter Total Marketing ($000) Domestic Marketing ($000) International Marketing ($000) Gross Additions (000) Subscriber Acquisition Cost
Q3 2010 81,238 79,419 1,819 136 $13.38
Q4 2010 62,849 55,785 7,064 517 $13.66
Q1 2011 104,259 90,580 13,679 404 $33.84

Source: NFLX Q4 2010 Financials, NFLX Q1 2011 Financials, Gross additions of international subscribers are my estimate for Q1 2011. Assumes that total marketing expense is divided between domestic marketing and international marketing.

The last number above ($33.84 acquisition cost) should cause concern. It is partially driven by the low number of gross additions due to my assumption of fewer defections, but even if this number was 588,000 (2x the net additions), the acquisition cost per subscriber would still be $23.26.

Decline in Free Subscribers (a.k.a. Potential Paying Subscribers)

The final cause for concern should be around its number of free domestic subscribers, which declined from just under 1.6 million at the end of 2010 to just under 1.4 million at the end of Q1 2011. This causes concern for two reasons:

  1. Free subscribers often become paying subscribers; as these numbers decline, it should negatively impact the ability to add paying customers in the next quarter.
  2. The cost of serving free subscribers is included in marketing expense, which means that the other marketing costs (advertising, etc.) have risen even more since overall per-subscriber acquisition costs went up.

In fairness, this pattern happened in the previous year, but to a slightly lesser extent -- hence the reason for concern (11% decline compared to an 8% decline year prior). It is not unreasonable to note this, since there are probably some non-customers who choose to test NFLX over the holidays when they have more free time or kids to keep entertained. After the new year passes, they opt not to continue and never become paying subscribers.

Conclusion

In my view, NFLX is a great company that delivers a good service. I've been a paying customer before, but am not one currently. I'm not questioning the merits of the company or its business model, just its growth prospects and hence its valuation. NFLX will continue to grow and expand, but the expectations are so high that it seems unlikely it will continue to defy the skeptics much longer.

Source: Digging Through Netflix's Q1 Financials