Brian Bolan, research analyst at Jackson Securities, sent a note to clients following Netflix's (NASDAQ:NFLX) latest earnings report in which he lowered his estimates and target price.
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.
Netflix posted a yet another good quarter in terms of revenue and earnings, but the outlook continues to disappoint. Revenue of $303.693M came in just below our estimate of $304.440M. Earnings per share came in well above our estimate of $0.23 per share at $0.37. When we backed out the effect of the gain from a legal settlement, earnings would have been $0.27 per share.
Gross margin was slightly lower than expected coming in at 35.2%, just shy of our estimate of 35.8%. The gross margin line continues to show weakness as margins were 91 basis points lower than the previous quarter and 186 basis points below year ago levels.
The real news, however, was that Netflix dialed down its marketing spend, which resulted in higher earnings. We had estimated about $64M in marketing spend for the quarter and were pleasantly surprised to see the company spend only $45M. This compared very favorable to last quarter which saw spending of $72M and was just 4% less than in the same period a year ago.
Net subscriber change in the quarter was a decrease of 55,000, compared to an increase of 303,000 in the same period a year ago and an increase of 481,000 in the first quarter of 2007. The decrease in subscribers is due mostly to the Blockbuster (BBI) Total Access program. Our estimates called for an increase of about 88,000 subscribers in the quarter.
Online video rental market
Blockbuster’s Total Access program is probably the main reason for the decrease in total subscribers for the quarter. We believe that most of the heavy users have already switched providers and the blood letting is likely over. Management more or less agrees with us via their guidance for next quarter. Guidance is calling for ending subscribers of 6.7M to 6.9M. The mid-point of the range is calling for an increase of 58,000. Elsewhere in the world of video rental, we note that Movie Gallery is facing significant troubles and is no longer a good comparison to Netflix.
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 4.6% compared to 4.3% in the same period a year ago and up from 4.4% 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 $44.02 per gross ad compared to $43.95 in the year ago period and down from $47.46 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 35.2% compared to 37.1% in the year ago period and 36.1% in the previous quarter.
Following a surprisingly high marketing spend total for 1Q07, management decided to dial down the ad dollars to $45M for 2Q07. This 37% decline from the previous quarter was certainly the extra juice the company needed to beat earnings estimates. We had estimated that marketing would be around 20% of totalrevenue but were pleased to see that the company came in at 15% of total revenue. Many will argue that this decrease in ad spending was directly responsible for the lack of growth in subscribers. We, on the other hand, believe that the marketing that spend had been too high of late and it needed adjustment. We also believe the shrinking number of subscribers had more to do with competition from Blockbuster than it did with Television and online advertisements.
We still believe that earnings are what investors purchase stocks for, and with our earnings estimate slipping lower yet again, we feel it necessary to lower our expectations for our target price. We had previous thought that a 29x multiple to reflected our expectation of growth in subscribers and earnings. The decrease in subscribers and limited prospect for growth in subscribers has helped us move our multiple lower to 25x this year’s estimate of $0.64. This equates to a price target of $16 per share.
We expect to deliver earnings estimates for 2008 sometime before the end of the third quarter.
NFLX 1-yr chart
For more on Netflix's latest quarter, see the company's Q2 2007 Earnings Call Transcript.