Netflix's 1Q07 Earnings: A Hard Pill to Swallow

Brian Bolan, research analyst at Jackson Securities, sent a note to his client on Neflix's 1Q07 earnings (see conference call transcript). Key excerpts follow:

Company Description

Netflix is the largest online movie rental subscription service providing more than 6.7M subscribers access to a library of more than 70,000 movie, television and other filmed entertainment titles on DVD. The company offers a variety of subscription plans, starting at $4.99 a month. There are no due dates, no late fees and no shipping fees. Subscribers select titles at the Netflix web site, receive them on DVD by U.S. mail and return them to us at their convenience using prepaid mailers. Netflix is also offering certain titles through its new instant-viewing feature.

Valuation and Recommendation:

The overwhelming number and size of competitors makes an investment in Netflix a hard pill to swallow. Competitive concerns have not abated and are likely to put continued pressure on Netflix throughout the remainder of the year. We are lowering estimates and target price and maintain a HOLD rating.

Earnings Summary

Netflix posted a surprisingly strong first quarter, but its outlook left much to be desired. Revenue of more than $305M topped our estimate of $303M. Earnings per share were in line with our estimate of $0.14 per share, but a shy of the Wall Street consensus estimate of $0.15 per share.

Gross margin was higher than expected, but was off set as churn ticked higher and subscriber acquisition cost [SAC] also increased.

The real news, however, was that Netflix lowered its guidance for subscribers and revenue. As we stated in our initiating coverage piece, we believe that subscribers are a key part of the valuation equation for Netflix. The market agreed with our theory and sent the stock lower by more than 9%.

Online video rental market

Blockbuster’s (BBI) TOTAL ACCESS program was blamed for the lowered guidance as subscribers were faced with an alternative that is lower in cost and offers almost twice as many movie views as the standard Netflix package. TOTAL ACCESS subscribers are basically given one in store movie for every movie they rent via the web.

Netflix management questioned the economics of the competitors program, and suggested that Blockbuster was essentially giving the store away for free. Clearly the land grab for customers is working, and we will learn more about the total subscriber numbers from Blockbuster when they report earnings on or about the second of May.

The economics of the program may force Blockbuster to increase prices, but that was not factored into guidance and we decided not to include it in our revised earnings estimates. At this time we do not see any reason for Netflix to increase its prices before a potential Blockbuster increase, but on the flip side, we do see the customers paying the higher end of the rate card to be the most likely to switch. This would probably cause ASP erosion.

Key business metrics

• Churn: Churn is a monthly measure defined as customer cancellations in the quarter divided by the sum of beginning subscribers and gross subscriber additions, then divided by three months. It is reported quarterly in the earnings release. Churn for the quarter was 4.4% compared to 4.1% in the same period a year ago and up from 3.9% from the previous quarter.

• Subscriber Acquisition Cost [SAC]: Subscriber acquisition cost is defined as total marketing expense divided by total gross subscriber additions. This metric is also found in the earnings release and is a good measurement of how effective the ad spending has been. SAC came in at $47.46 per gross ad compared to $38.47 in the year ago period and $44.31 in the previous quarter.

• Gross Margin: Gross margin is a key metric for investors to follow as it tells how effective the underlying model is performing. The higher the gross margin, the better the model is working. From time to time, the company has opted to reduce gross margin in order to help secure more market share in hopes that over time the customers will become more valuable to them. Gross Margin for the first quarter was 36.1% compared to 33.8% in the year ago period and 38.9% in the previous quarter.

Ad Spend

We were a little surprised to see an aggressive ad spend in the quarter in the face of the new Blockbuster offering. With more then $72M spent on marketing only 481K new subscribers signed on. We were looking for marketing spending to be about $6M lower. Going forward, we expect marketing to be at least and likely more than 20% of total revenue. Management noted that “word of mouth” style subscriptions were lower in the quarter and may be lower than expected going forward due to competitive concerns.

Valuation

Our valuation based on a multiple of earnings seems appropriate and is just a little under where the market took Netflix today. When we started coverage of Netflix we leaned heavily on the earnings multiple, yet noted our concern for a valuation that encompassed the idea of the number of subscribers. At this time we believe that in our multiple needs to remain roughly the same as we work on a better valuation equation that encompasses the subscriber number. That stated, a 29X multiple is quite a rich one, but still shows that we expect growth from the company for the remainder of 2007 and into 2008. The 29X multiple gives us a target price of $20.80, which we will round up to $21.00.