NFLX: Setting the Pace--Strong 1Q06 Results
• NFLX reported strong pro forma 1Q06 EPS of $0.09, beating our $0.06 estimate and consensus. The upside was attributable to stronger gross margins and subscriber additions. We look for NFLX to aggressively reinvest its upside over the course of 2006.
• NFLX reported a strong quarter, especially considering the heavy promotion spending by BBI. While most of this upside will be reinvested, these investments combined with the strong sub add trends increase our conviction in NFLX’s long term growth prospects.
• We continue to like NFLX’s ability to: 1) deliver superior entertainment value; 2) extract operating margin improvements as it scales its business; and 3) create higher barriers to entry that bode well for the company’s ability to maintain dominant market share and drive increasing shareholder value. We maintain our above guidance estimates, $39 price target, and Buy rating.
NFLX reported strong pro-forma (including option expense) 1Q06 EPS of $0.09, beating our $0.06 estimate and consensus. The quarter was led by stronger revenue growth, subscriber additions, and gross margin. We see the quarter’s gross margin improvement as the biggest surprise at 43.7%, 420 basis points higher than our 39.5% estimate. Although NFLX reclassified some of its line items (see below), making margin comparisons more difficult to assess, it appears that some of the upside NFLX reported was tempered by a higher operating expense base. Operating income came in at $4.8 million, easily topping our $736,000 estimate. Non operating items were also favorable. Interest income was $2.5 million vs. our $1.7 million estimate, while taxes and shares were slightly below our estimate (added about $0.01). We would note that on a GAAP basis, EPS beat our estimates by $0.05 vs. $0.03 on a pro-forma basis, reflecting a lower than expected option expense.
Overall, NFLX reported a strong quarter, especially considering the heavy promotion spending BBI ran during the quarter. While we expect most of this upside will be reinvested over the course of 2006, these investments combined with the strong sub add trends increase our conviction in NFLX’s long term growth prospects. We maintain our above guidance estimates, $39 price target, and Buy rating. We continue to like NFLX’s ability to: 1) deliver superior entertainment value; 2) extract operating margin improvements as it scales its business; and 3) create higher barriers to entry bode well for the company’s ability to maintain dominant market share and drive increasing shareholder value. In the past, the company provided a penetration rate for the San Francisco Bay area.We heard today that NFLX has achieved a relatively high penetration rate of 19% in Jamaica Plain, a community near Boston, and 22% in Menlo Park, which in our view, is clearly an indication of the likely penetration curve the company can have in all major cities.
METRICS AND TAKEAWAYS
On balance, NFLX’s metrics looked solid. Pricing was down 10.3% to $15.78, just shy of our $16.17 (-8.1%) estimate. Monthly churn decreased 17.8% year over year to 4.14% vs. our 4.02% estimate. However, these headwinds were more than offset by improvements in SAC (subscriber acquisition cost) and gross subscriber additions, which totaled 1.4 million (+45.7%) vs. our 1.2 million (+29.7%) estimate. SAC came in at $38.06 (+0.5%), well below our $40.01 (+7.4%) estimate. Ironically, management indicated that they wanted to spend another $2 million on marketing this quarter that would have buffered some of the upside while helping the company to add more subs longer term.
Management expects to reinvest its upside into future quarters, which is the basis for the company raising its revenue and subscriber guidance while leaving its earnings guidance unchanged. NFLX expects SAC to return to $36 to $44 range over the course of 2006 (we see the upper end as more likely) with a lower pricing assumption. This increased investment should be coupled with steadily improving gross margins and strong subscriber growth. Furthermore, we continue to believe that reductions in pricing put NFLX in a better position to capture subscribers while increasing the barriers to entry.