Netflix Puts Streaming Into Overdrive With DVD Biz Peaking

Jefferies & Co. said Netflix Inc.'s (NASDAQ: NFLX) second quarter results missed revenue and subscribers addition estimates on higher churn, while third quarter guidance was below consensus.

"That said, the recent price hike and international expansion should positively impact the numbers starting in fourth quarter of 2011. We maintain a Hold rating on full valuation on relatively aggressive long-term subs/margin assumptions, and a less favorable competitive environment going forward," said Youssef Squali, an analyst at Jefferies.

Netflix's revenue for the second quarter was up 51.7 percent to $788.6 million and net subscribers increased 1.96 million, both short of consensus estimates at $791 million and 2.07 million, respectively. Earnings of $1.26 per share was well ahead of the Street estimates of $1.11 per share, however, on higher gross margin/lower marketing spend.

The company's second quarter ending subs were about 100,000 shy of consensus of 25.7 million. Of concern, domestic churn increased 30 basis points sequentially to 4.2 percent (even before the price hike was announced), which Jefferies believes is a by product of strong net adds in first quarter of 2011.

Squali said very little sequential revenue growth is expected in third quarter, since higher churn from the price hike hits third quarter results but higher average revenue per user (ARPU) only begins to take affect from mid-September.

Netflix's management provided third quarter guidance, expecting revenue of $799.5 million to $828.5 million, subscribers of 25.8 million to 26.9 million, and earnings of $0.72 to $1.07 per share. Consensus estimates revenue of $846 million, subscribers of 28.2 million and earnings of 1.09 per share, respectively. At the midpoint of guidance, revenue is about 4 percent below and EPS is about 18 percent below the Street view.

The company's third quarter domestic net additions are expected to be lower than last year. But full quarter of fee hike should yield first $1 billion-plus revenue quarter in fourth quarter, Squali said in a statement to clients.

While third quarter guidance disappoints, management is intent on returning domestic net additions to year-over-year growth in fourth quarter; that and higher ARPU should yield the company's first $1 billion-plus of revenue quarter.

Squali expects the stock to remain range bound until he start getting confirmation of early traction with both US subscriber reaccleration in fourth quarter of 2011 and international expansion in first half of 2012.

Squali believes that a higher stock price is dependent on an almost flawless execution on streaming and international.

"We believe that the primary reason behind management's recent price hike decision resides in their acknowledgment that the DVD business has finally peaked, and as such it was time to run it for cash flow. This move plus the fee hike should have materially positive implications on gross margins in fiscal 2012," said Squali.

Streaming Developments

Sony Pictures movies are still down from Netflix, as the contract dispute between Sony and Starz goes on. Netflix's management is hopeful that two partners will resolve the issue soon. Netflix continues to be in discussions with Starz to renew their licensing agreement beyond first quarter of 2012.

Netflix intends to start in Latin America (43 countries) with relatively more content than the company’s Canada launch. The Netfix management expects to have more content to announce once it gets closer to launch.

Squali said management reaffirmed that it plans to enter one or two new countries in first quarter of 2012. Content licensing discussions are under way.

Competitive Update

Netflix’ largest competitor overtime is still considered to improved multichannel video programming distributor (MVPD) service, or TV Everywhere from cable/satellite TV incumbents.

Squali said that to the extent these offerings offer more Internet video on demand, it could reduce the attractiveness of a supplementary service like Netflix.

Amazon Prime has recently added thousands of films and TV shows, but Netflix has far more streaming content and management has not detected an impact on the business, Squali said.

Hulu Plus is much smaller than Netflix, adding 325,000 subscribers in second quarter versus close to 2 million for Netflix. However, Netflix management noted that it is likely to be sold near term and it is unknown who will run it and how much they will invest, Squali added.

Facebook Integration Update

Netflix's management expects to provide an update on the Facebook integration before the next earnings report, however, this offering is not expected in the U.S.

Netflix's management noted that the Video Privacy Protection Act discourages the launch domestically, since it is ambiguous when and how a user can give permission for his or her video viewing data to be shared. If lawmakers pass a clarification, HR2471, Netflix would be able to offer the Facebook integration to U.S. subscribers.

The brokerage increased its price target on shares of Netflix to $265 from $240, while maintaining its "hold" rating. The brokerage raised its 2011 EPS estimate for Netflix to $5.38 on revenue of $3.41 billion from $4.61 on revenue of $3.37 billion, and its 2012 estimate to $11.23 on revenue of $5.04 billion from $6.27 on revenue of $4.56 billion.

Netflix stock closed Monday's regular trading up 1.79 percent at $281.53 on the NASDAQ Stock Market, while in the after-hours the stock fell 10.18 percent to $252.88.