Netflix Q3 2014 Earnings Review

  • Netflix reported a miss on subscriber figures for the most recent quarter, even as earnings and revenues either met or beat expectations.
  • In Q3, Netflix free cash flow trends have worsened, which was driven by the upfront cost of content that has yet to be amortized.
  • Netflix’s guidance figure indicated a much lower contribution margin figure in foreign markets; as a result the full-year EPS figures will miss consensus estimates.
  • Earnings growth is highly unlikely in the short term. However, the company may return to respectable growth rates once the European subscription business operates at a much more meaningful scale.
Netflix Q3 2014 earnings review

Netflix (NASDAQ:NFLX) announced Q3 2014 results that weren’t all that great. Investors may be put through another investment phase, which will lead to muted or even declining earnings growth trends in favor of revenue growth. Furthermore, competition in the form of HBO, Hulu Plus, and Amazon Prime continues to heat up. I estimate that full-year revenue will come in at around $5.6 billion, which will beat consensus revenue estimates of $5.51 billion.

Netflix continues to increase its content investment at the highest rate it possibly can without risking the possibility of becoming insolvent.  While Netflix highly prioritizes content investment, competitors are also ramping up content spend (Amazon), whereas Time Warner has opted to make HBO a stand-alone streaming video on demand service.

Amigobulls' Netflix stock analysis reiterates a cautious approach to this stock. Netflix valuation videograph factoring in the latest financials can be viewed below. 

Netflix Q3 2014 Earnings Results

Netflix reported a miss on subscriber figures. Management believes that the modest increase in pricing reduced the subscriber growth rate.

(In millions except per share data and Streaming Content Obligation) 2013 Q3 2013 Q4 2014 Q1 2014 Q2 2014 Q3 2014 Q4 (Forecast)
Total Streaming:
Revenue $884 $962 $1,066 $1,146 $1,223 $1,305
Contribution Profit $92 $117 $166 $212 $220 $165
Contribution Margin (as %) 10.4 12.2 15.6 18.5 18.0 12.6
Paid Members 38.01 41.43 46.14 47.99 50.65 54.10
Total Members 40.28 44.35 48.35 50.05 53.06 57.06
Net Additions 2.73 4.07 4.00 1.69 3.02 4.00

Source: Netflix

As you can tell, net additions came in at 3.02 million, which fell short of prior guidance at 3.69 million. The miss on subscriber additions and the increase in pricing resulted in $1.223 billion in revenue. Just shy of the $1.224 billion in revenue that management had estimated in the prior quarter. The revenue figure could have been significantly better assuming subscriber growth was in-line along with the increase in pricing (monthly subscription rate increased from $7.99/month to $8.99/month).

The miss on subscriber additions isn’t surprising. As is, it’s difficult to gain further penetration into a more and more saturated market. The increased pricing acts as a barrier of entry, putting the product out of reach for a portion of the market.

Netflix Net Income and free cash flow Source: Netflix

Netflix stock declined by 26% in afterhours trade. The decline in valuation was driven by a significant reduction in free cash flow, and concerns over whether Netflix will be able to grow subscriber figures and increase pricing concurrently. Streaming obligations have increased, which resulted in the decline in free cash flow. To put it more simply, the expense recognition of long-term content commitments, and the actual cash outflows are different.

Netflix Content obligations payment schedule Source: Netflix

Streaming content obligations are expected to increase, which is indicative of future cash out flows. However, the rate at which Netflix amortizes the content licenses is different from the actual cash outflow, which is why net income is correspondingly higher than free cash flow. Going through an added investment phase, but with limited subscriber additions is the primary factor as to why Netflix reported a miss on earnings, and why the stock fell so much in the afterhours.

While streaming content obligations are large in relation to sales, the impact on the income statement should be incremental as content obligations cost less further into the future. To explain the accounting behind content obligations you would have to go back to double-entry book keeping. The content liabilities are actually future expenses that have not been recognized yet. However, when comparing earnings to prior years, you’ll find that both expenses and content obligations have increased. That’s because content obligations in the past, are now cost of revenue in the form of amortization in the present. Therefore, the liabilities that management mentions in conference calls are future expenses that are paid for with future revenues. Therefore, the likelihood of insolvency is fairly low, unless if subscriber figures decline considerably.

Netflix reported Q3 EPS of $0.96, which beat analyst estimates of $.93. Furthermore, the company offered EPS guidance for the next quarter at $.44. The full-year EPS figure for FY 2014 should be $3.41, which is well below the $3.81 EPS anticipated for FY 2014. The miss in guidance was driven by higher than anticipated costs in the international streaming segment, which will have a -24.5% contribution margin in Q4 2014. The reduction in earnings growth will be driven by an up-tick in content costs, as content licensing agreements apply on a regional basis. This means that the pre-existing content library that Netflix carries cannot be carried over into other markets.  Netflix will have to buy additional content rights in both local and domestic markets in order to compete internationally.

Conclusion

While, earnings results weren’t all that great, subscriber additions should be in-line in the next quarter.  After having analyzed sales data based on the tiered pricing model that was recently implemented, management’s forecast for subscriber addition will be much more accurate. Also, expansion into Europe should drive revenue enough so that Netflix will reach its own internally forecasted sales figures in the next quarter.

However, the additional sales will come with increased up-front costs in the form of content investment. It’s unlikely that the company will be able to generate a significant amount of earnings growth over the near-term, but may produce a more sustainable pattern of bottom line growth assuming the business model scales in foreign markets.

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