(NFLX) Netflix’s Fourth Quarter Soars on Higher Users

Netflix Inc. (NFLX) reported fourth quarter 2011 diluted earnings of 73 cents per share, breezing past the Zacks Consensus Estimate of 55 cents per share and management’s guidance range of 36 cents to 70 cents. However, EPS declined 16.1% year over year, primarily due to higher operating expenses in the quarter.

Total revenue increased 47.0% year over year to $875.6 million, surpassing the Zacks Consensus Estimate of $862.0 million. Most importantly, subscriber growth rebounded in the reported quarter after the company lost 800K subscribers in the third quarter. Shares surged 15.87% to $110.12 in after-hours trading, following the earnings release.

Quarter Details

Domestic revenue increased 43.0% from the year-ago quarter to $846.6 million, which surpassed management’s guided range of $816.0 to $845.0 million. International operations generated revenues of $29.0 million, up 27.8% year over year and were at the higher end of management’s guided range of $25.0 million to $30.0 million.

The year-on-year revenue growth was primarily boosted by newer additions in the total subscriber base. At the end of fourth quarter 2011, total number of subscribers (Domestic and International) was 26.3 million, an increase of 31.5% from the prior-year quarter.

Significantly, on a sequential basis, Netflix gained 600K million subscribers (both domestic and international).  Netflix’s domestic subscriber base grew approximately 220k during the fourth quarter. Free subscribers, as a percentage of ending subscribers, decreased to 6.3% from 8.0% reported in the year-ago quarter.

Average monthly revenue per paying subscriber increased 5.7% year over year to $12.35. However, churn increased 160 basis points (bps) on a year-over-year basis to 5.3% at the end of the quarter.

Gross profit increased 46.5% from the year-ago quarter to $300.4 million. Gross margin, however, decreased 10 bps year over year to 34.3% due to higher subscriber acquisition costs.

Operating expenses shot up 81.2% year over year to $229.5 million, due to higher marketing expenses (up 81.8% year over year), technology and development expense (up 75.8% year over year) and general and administrative expense (up 93.0% year over year) in the quarter.

Operating profit decreased 9.7% from the year-ago quarter to $70.9 million. Operating margin was also down 510 bps from the year-ago quarter to 8.1%, primarily on the back of increased spending for streaming content and higher licensing fees.

Net income decreased 13.5% year over year to $40.7 million in the quarter. Net margin contracted 320 bps to 4.7% from the year-ago quarter.

Balance Sheet and Cash Flow

As of December 31, 2011, Netflix had $797.8 million in cash and cash equivalents (including short-term investments) compared with $365.8 million as of September 30, 2011. Long-term debt was $200.0 million at the end of December 31, 2011.

Cash flow from operating activities was $65.5 million in the fourth quarter of 2011, compared with $49.5 million in the third quarter of 2011. Free cash flow increased to $33.9 million from $13.8 million in the previous quarter.

Quarter Ahead

For the forthcoming quarter, management expects loss per share to be in the range of 49 cents to 16 cents, well below the Zacks Consensus EPS Estimate of 22 cents per share. Net loss is expected to be in the range of $27.0 million to $9.0 million.

Domestic and International revenue is expected to be in the range of $496.0 million to $511.0 million and $38.0 million to $44.0 million, respectively. Domestic DVD revenue is expected to be in the range of $308.0 million to $322.0 million for the first quarter of 2012.

Management expects subscribers in the consolidated domestic market and in the international market to range from 22.8 million to 23.6 million and 2.5 million to 3.1 million, respectively. The U.S. DVD subscriber base is expected to be in the range of 9.4 million to 10.0 million.

Management expects the subscriber growth to be negatively impacted by increasing attrition rate in the DVD segment. However, strong growth in streaming customer base in both US and International will limit customer base erosion in 2012.

Moreover, Netflix continues to pursue international expansion and recently ventured into the UK and Ireland. These ventures along with rise in DVD prices and increasing license and content related fees are going to hurt profitability going forward.

Our Recommendation

Although Netflix reported better-than-expected fourth quarter results, we believe that earnings growth will take some time to rebound. Nonetheless, Netflix’s improving content portfolio and international expansions are noteworthy. Despite the higher costs, we think Netflix will probably see sales strengthening, as subscribers take note of the improving portfolio. This would ultimately enable the company to build a position for itself over the long term.

However, we believe that increasing costs related to licensing and renewal fees and higher capital expenditure due to international expansions can hurt growth in the near term. Moreover, increasing competition from Amazon.Com Inc. (AMZN) will remain an overhang on the stock going forward.

We have a Neutral recommendation on Netflix shares over the long term. Currently, Netflix has a Zacks #3 Rank, which implies a Hold rating over the short term.

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