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Netflix (NASDAQ:NFLX) saw a return to profitability in its second quarter, but many concerns, which scared away investors yesterday, still linger. The stock dropped 19% to $65 in after-hours trading, primarily due to concerns over the company not being likely to reach its domestic subscriptions target for this year, and the expected return to losses when the company launches its yet unnamed market in the fourth quarter.

The stock is down 22% since our recommendation on July 9th, 2012. We disagree with Julian Roberston's opinion of a turnaround, and still do not recommend a long position in the stock, as Q2 results don't seem to be a game changer for NFLX.

Q2 Results Vs. Expectations:

  • Q2 EPS turned out to be 11 cents per share, which lies in the upper half of the guidance issued earlier this year of -10-to-14 cents per share. This EPS result has significantly beaten analyst estimates of 5 cents, but was far less than the $1.26 per share in 2Q2011.
  • Net income was $6 million compared to $68 million in last year's 2nd quarter. This income includes a loss of $89 million from the international streaming business, and a loss in revenues from the declining DVD business. However, this is still better than Q1's loss of $5 million.
  • Revenues increased 13% compared to the same quarter last year. The low profits indicate that the costs from domestic and international streaming businesses continue to rise, although for this quarter, the rise was almost in line with revenues.
  • The company reiterated its 7 million domestic streaming subscription target for the current year, emphasizing that it would only be possible if NFLX was able to get additions in the upper range of its domestic subscription guidance for 3Q2012 i.e. 1 million to 1.8 million. In Q2, it was able to add 0.53 million domestic subscriptions with total streaming subscriptions now at 27.56 million (4% more than Q12012 and within the guidance range).

Below are the reasons why Netflix is still not a buy:

  • There are doubts over whether the rising viewing hours would lead to enough 'word of mouth' promotion to trigger a significant rise in subscriptions or lesser churn.
  • There will be competition from channels that are showing the Olympic Games.
  • Licensing (particularly for the more wanted TV content) and content costs continue to rise, especially for the international market. As content is a primary driver of subscriptions, these costs will need to be better managed, or subscribers need to be added more quickly if profitability is to be maintained. $1.2 billion are due to be paid to content providers like Disney (NYSE:DIS), CBS Corp (NYSE:CBS) and Warner bros. (NYSE:TWX).
  • There is a lot of competition from BskyB (edge in content), Sky's Now TV (£15/month) and Amazon (NASDAQ:AMZN)'s LoveFilm in the U.K., and from HuluPlus (priced the same as Netflix), HBOGO (a bundled offer with 29 million subscribers) and Amazon Prime (priced at $79/year) domestically. There is competition from cable networks as well. Netflix does not have the margin to increase its pricing to cover rising content costs because it would drive customers away, as seen from the price hike in 2011.
  • We expect Netflix will not reach the 7 million mark based on the estimates below

Q1 10

Q2 10

Q3 10

Q4 10

Percentage change from previous quarter (2010)

-39%

87%

60%

Q1 12

Q2 12

Q3 12

Q4 12

Net additions after applying 2010 percentage change(in millions)

1.74

0.53

1.4 (midpoint of guidance range)

2.24

Future Outlook:

The company expects its Q3 EPS to be in the range of -10 cents-to-14 cents per share. The revenue guidance is $890-$911 million (including streaming and DVD segments). Analysts expect an EPS of $0.11 and revenues of $906 million for Q32012.

The company has announced international expansion for the 4th quarter. Although the company has yet to announce details of the market that they are planning to enter in Q3, they have already said that this expansion would mean a return to losses.

Valuation:

We reiterate our earlier recommendation of staying away from NFLX owing to its content acquisition costs and less than targeted growth in subscriptions, which are important for covering costs for content as well as international expansion. The company should leave its international expansion plans for a while, and concentrate on building its subscriber base in the regions it is currently engaged in to support later expansion.

Based on the 16% long term growth rate for earnings and the range of P/E values, including the trailing P/E of 27x, the valuations come out to be:

*At 16% long term growth rate.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: No Turnaround For Netflix