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Netflix Update:

Netflix (NFLX) had given a target of 7 million new subscribers for its domestic streaming segment for the year 2012. In the first quarter of this year, the company was able to add 3 million customers to its streaming subscriber base (1.74 million were domestic). Q2 results will determine whether the 7 million mark is achievable. Many analysts already think that the 7 million mark is unrealistic, citing significant competition and continuous spending required for new content as the main reasons for their opinion.

The stock traded up on the news of 1 billion viewing hours in June. This month, the hours are up 20%. In our earlier article, we said that this viewing record does not mean a significant jump in profitability; rather, it just implies that viewers like the content on offer. Shows like "Dora the Explorer" and "Mad Men" are quite popular these days, but soon the company will have to invest again in new content, once these titles get old. Unless Netflix is able to retain customers with attractive programs in the future, this 1 billion is of little consequence.

In its investors letter Q12012, the company stated that it expects gross additions in subscribers to follow the same pattern as 2010, though net additions for Q2 would be less than 2010 due to yearly seasonality effect on a larger than 2010 customer base. 2010 saw net additions of 7.7 million in the subscriber base, with a churn of roughly 4%. Below is a table showing the additions in 2010.

Below are calculations for 2012 based on percentage changes in net additions for 2010:

 

Q12010

Q22010

Q32010

Q42010

Percentage change from previous quarter (2010)

 

-39%

87%

60%

     
 

Q12012

Q22012

Q32012

Q42012

Net additions after applying 2010 percentage change (in millions)

1.74

0.87*

1.6

2.56

*As it is expected to be less than Q22010 because of larger seasonality effect. 50% of 1Q2012.

Our domestic net additions estimate comes out to be 6.77 million (based on 2010 growth rates) for 2012. This does not include the effects of increased churn and competition this year. Therefore, the company will likely fall short of the 7 million net domestic additions mark. A substantial increase in streaming subscriptions is vital because NFLX's DVD business has been declining, and streaming is needed to not only support the company's international losses, but also expenditures incurred to acquire new content (which is the key to acquiring and retaining customers).

In spite of all the discussions about subscribers, the main driver for the stock remains profitability. Although streaming subscriptions have increased from 23 million in Q32011 to 26 million last quarter, profitability has continued to decline. Net income fell from $35 million for the quarter ending December 2011 to -$4.5 million for the last quarter. The cash flow from operations shows a similar story, with a decline of 70% from Q42011 to Q12012. This is due to an unprofitable international streaming business, and the declining domestic DVD business. 41% of the new subscriptions in Q12012 were international, but still the losses from these operations almost doubled from $60 million to $103 million, largely due to content costs. The company's primary concern at the moment should be bringing a turnaround in international operations, which have yet to show a profitable quarter.

Moreover, competition in the U.S. and international markets is one of the main reasons why Netflix might not be able to achieve the subscriber target. With competitors like Hulu, and Amazon (AMZN)'s prime instant video and cable networks, either pricing their offerings at lower rates or having an edge in content, Netlix faces an uphill challenge.

See our previous article for details on Netflix's ails.

Next Quarter Estimates and Guidance:

Analyst estimates for the current quarter, whose earnings are to be released on Tuesday, are:

  • Analyst mean for EPS estimate for 2Q2012 is 47 cents. This is an increase of $1.27 from last quarter's EPS. The guidance for 2Q was -$0.1-to-$0.14.
  • The company expects domestic subscriptions to be 23.6-24.2 million (23.41 in 1Q2012), and international subscriptions to be 3.45-4 million in 2Q2012 (3.07 million in 1Q2012).

Valuation:

NFLX is trading at an EV/EBITDA of 13x compared to Comcast (CMCSK)'s 6x, Time Warner Cable (TWC)'s 7x and Amazon's 54x.

JPMorgan (JPM) gives a neutral rating for Netflix. The price target is $87, based on a 12x 2013 EBITDA of $338mn.

As before, we advise against a long position on the stock, until there is an indication of improvement in profitability (particularly from the loss-making international operations) by ensuring better management of content costs, and faster growth in streaming subscriptions, coupled with lesser churn, which can offset the lost revenue from DVD sales.

Source: When Should You Buy Netflix?