Netflix Continues To Stagnate

| About: Netflix, Inc. (NFLX)
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After the bell on Tuesday, streaming movie and TV leader Netflix (NFLX) reported its fiscal second quarter earnings. Overall, the numbers were decent, but forward looking guidance was less than impressive. As Netflix moves towards a streaming only business, throwing away its DVD segment, conditions are going to be tough. Right now, Netflix continues to stagnate. Let's look at the results.

Q2 Results:

I've compiled an overview of Netflix's results in the table below, comparing the reported results to the guidance given by the company when they reported Q1 results.

Domestic Streaming Q2 Guidance Q2 Actual
Total Subscriptions 23.6m to 24.2m 23.94m
Paid Subscriptions 22.3m to 22.9m 22.69m
Revenue $526m to $534m $533m
Contribution Profit $72m to $84m $83m
Domestic DVD Q2 Guidance Q2 Actual
Total Subscriptions 8.95m to 9.35m 9.24m
Paid Subscriptions 8.9m to 9.3m 9.15m
Revenue $287m to $294m $291m
Contribution Profit $126m to $138m $134m
International Streaming Q2 Guidance Q2 Actual
Total Subscriptions 3.45m to 4.0m 3.62m
Paid Subscriptions 2.8m to 3.25m 3.02m
Revenue $60m to $67m $65m
Contribution Profit (Loss) ($98m) to ($86m) ($89m)
Consolidated Global Q2 Guidance Q2 Actual
Revenues $873m to $895m $889m
Net Income ($6m) to $8m $6m
EPS ($0.10) to $0.14 $0.11

In terms of the domestic streaming segment, Netflix was slightly ahead of the midpoint they guided to for total subscriptions. Paid subscriptions fared a little better in terms of the midpoint. Revenues were at the high end of the range, and contribution profit was as well. Contribution margin for this segment rose to 15.6% from 13.2% in Q1.

In terms of the domestic DVD segment, total subscriptions came in above the midpoint. Paid subscriptions did as well, but not by as much. This means that they didn't lose quite as many DVD customers as they originally thought, but they are still losing them. Revenue was just ahead of the midpoint, and contribution profit fared a little better. Contribution margin increased to 46.0% from 45.6% in Q1.

In terms of the international streaming segment, Netflix was mixed. While paid subscriptions were basically at the midpoint, total subscriptions fell short of the midpoint. However, both revenue and the contribution profit (loss) were ahead of the midpoint. Netflix will face increased international competition in the UK going forward as BSkyB has launched a similar type movie service.

Overall, Netflix revenues were above the midpoint of their given guidance, but just in-line with analyst expectations. Both net income and earnings per share were at the high end of the range, beating analyst estimates for $0.05. This is especially interesting considering that the diluted share count rose by more than 3 million shares in the quarter, from 55.456 million to 58.809 million.

Margin Analysis / Rising Costs:

As Netflix kills off the DVD business, it is focusing on a streaming only service. That is a lower margin business, and is reflected in recent results. I'm going to provide two margin tables. The first table shows second quarter margins over the past four years.

Q2 Margins 2009 2010 2011 2012
Gross 34.09% 39.41% 37.87% 27.64%
Operating 12.92% 14.88% 14.60% 1.82%
Profit 7.94% 8.37% 8.65% 0.69%

Netflix revenues were up 12.75% over the prior year period. Remember that number. In terms of the cost of revenues, subscription costs were up 36.3% while fulfillment costs were actually down 3.21%. Total costs of revenues were up 31.32%. That explains why gross margins plunged by 10 full percentage points.

In terms of operating expenses, marketing costs rose by more than 24% over the prior year period. Technology costs were up nearly 41%, and general costs declined by about 3%. Overall, operating expenses rose by more than 25%, about twice as fast as revenues rose. Combine the operating expenses with the lower gross margins, and you can see that operating margins fell by nearly 13 full percentage points. It is hard to make money when operating margins are below 2%.

While interest expenses were lower than the prior year period, Netflix's interest and other income swung from a $1.01 million gain to nearly a $0.5 million loss. Netflix also saw its effective tax rate for the quarter rise from 38.45% to 42.15%. For the bottom line, profit margins were a measly 0.69%, 8 full percentage points below last year's period.

This isn't a one quarter issue in terms of margins. Netflix's business is going to be like this until international operations start catching up.

The second margin table proves how Netflix's margins have been coming down recently.

Margins 3Q 2010 4Q 2010 1Q 2011 2Q 2011
Gross 37.73% 34.42% 39.02% 37.87%
Operating 12.56% 13.16% 14.23% 14.60%
Profit 6.86% 7.90% 8.38% 8.65%
Margins 3Q 2011 4Q 2011 1Q 2012 2Q 2012
Gross 34.71% 34.31% 28.27% 27.64%
Operating 11.78% 8.09% -0.22% 1.82%
Profit 7.60% 4.65% -0.53% 0.69%

Netflix has seen year over year declines over the past few quarters. The company has gone from averaging about 7% to 8% on the bottom line to being completely flat.

Balance Sheet Update:

The following table shows some key financial numbers for the company over the past few quarters.

Key Financials 4Q 2010 1Q 2011 2Q 2011 3Q 2011 4Q 2011 1Q 2012 2Q 2012
Current Ratio 1.65 1.47 1.33 1.23 1.50 1.42 1.43
Working Capital $252,388 $231,284 $239,230 $222,147 $611,315 $612,075 $638,941
Debt Ratio 70.45% 74.71% 78.73% 80.20% 78.85% 80.94% 80.21%
Diluted Shares 54.194m 54.246m 53.909m 53.870m 55.439m 55.456m 58.809m

Netflix increased its working capital slightly, but the current ratio stayed flat. The debt (liabilities to assets) ratio remains above 80%. Also, the diluted share count rose by more than 3 million in the quarter, a rise of about 6%. As I've detailed in the past, Netflix is not buying back shares right now, so shares will continue to be diluted by executive options. On the conference call, CFO David Wells answered why the diluted share count rose so much.

Because we swung to a profit. GAAP accounting would have you bake in the fully dilutive effects of the convert we did in November and that's not the case when you're at a loss -- in a loss position.


I've summarized the guidance Netflix gave in the table below, compared to the Q2 results.

Domestic Streaming Q2 Actual Q3 Guidance
Total Subscriptions 23.94m 24.9m to 25.7m
Paid Subscriptions 22.69m 23.5m to 24.1m
Revenue $533m $552m to $559m
Contribution Profit $83m $85m to $95m
Domestic DVD Q2 Actual Q3 Guidance
Total Subscriptions 9.24m 8.35m to 8.65m
Paid Subscriptions 9.15m 8.3m to 8.6m
Revenue $291m $266m to $273m
Contribution Profit $134m $120m to $132m
International Streaming Q2 Actual Q3 Guidance
Total Subscriptions 3.62m 3.9m to 4.4m
Paid Subscriptions 3.02m 3.3m to 3.8m
Revenue $65m $72m to $79m
Contribution Profit ($89m) ($105m) to ($93m)
Consolidated Global Q2 Actual Q3 Guidance
Revenues $889m $890m to $911m
Net Income $6m ($6m) to $8m
EPS $0.11 ($0.10) to $0.14

The overall revenue midpoint just above $900 million is disappointing, as analysts were expecting almost $906 million going into today. Analysts were also expecting $0.11 in earnings, so Netflix's guidance there is disappointing as well.

Netflix is aiming for a profit in Q3, but they also stated that results will be impacted a little by the Olympics, as the world will spend more time watching the games, thus not spending as much time with Netflix.

Netflix also announced that they are definitely aiming to enter a new European market in Q4. As a result, they will return to a global loss again. This is going to be the pattern we will see with Netflix. Every time they return to profitability, they will expand somewhere else, which will cost more and more losses. I wrote that statement before Netflix's call started, and CEO Reed Hastings backed it up on the call when this discussing occurred (the following is taken directly from the call).

So don't expect any meaningful profits for quite a while. In fact, if they decide to keep expanding international every time they go profitable, you might not see meaningful profits for 5, 10 years, maybe ever? It is something to really think about.

Conclusion / Recommendation:

I've been in favor of shorting Netflix on pops for quite a while, and I was suspicious of the recent rise above $80 after Netflix announced 1 billion viewing hours for June. Tuesday's results proved that Netflix just isn't there yet. Things are improving, but at a snail's pace.

For the full year, analysts were expecting $0.11 in earnings. Now that Netflix will lose money in Q4, it is possible that the company could lose money for the full year.

But my recommendation is to short the name based on valuation. We can assume that the losses in contribution margin from the DVD segment will be made up by the gains in contribution margin from the domestic streaming segment. That means all progress will be made from the international segment. But if Netflix expands again in Q4, I expect Q1 could be soft as well.

That means that current analyst estimates for earnings of $2.12 in 2013 may be a little high. For now, let's say Netflix gets $2 in earnings. Even at the Wednesday mid-day price of $60, a $20 decline after the earnings report, Netflix still trades at 30 times 2013 earnings. That for a company whose revenues are growing in the mid-teens, percentage wise, has a terrible balance sheet, and is moving towards a lower margin business. Plus, if they continue to expand every time they reach profitability, they might not make any money in 2013. That would push the valuation even higher.

The 52-week low for Netflix was $60.70. That number was taken out on Wednesday and shares are likely to continue lower.

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