(NFLX) Netflix Excels in Fourth Quarter

Shares of Netflix Inc. (NFLX) surged 35.4% ($36.54) in after-hours trading after the streaming service provider reported better-than-expected fourth quarter 2012 results. Earnings per share (“EPS”) of 13 cents were significantly ahead of the Zacks Consensus Estimate of a loss of 12 cents per share.

Revenue

Total revenue increased 7.9% year over year to $945.2 million and beat the Zacks Consensus Estimate of $935.0 million. Moreover, the company reported sequential revenue growth of 4.4%. Robust subscriber additions in Netflix’s streaming business (both domestic and international) led to the better-than-expected top-line performance.

Notably, Netflix’s paid streaming subscriber base (both domestic and international) increased 8.76 million from the year-ago quarter and 2.87 million in the previous quarter to 30.36 million.

At the end of the fourth quarter, revenue from Netflix’s domestic streaming business increased 23.8% from the year-ago quarter to $589.5 million. Sequentially, the segment revenue increased 6%. Netflix’s domestic streaming customer base increased 2.05 million on a sequential basis and 5.4 million from the year-ago quarter to 27.1 million.

Revenue from international streaming business was up a staggering 250% year over year and 30.5% sequentially to $101.4 million. Subscriber base also increased to 6.1 million from 1.9 million in the year-ago quarter and 4.3 million in the previous quarter.

However, Netflix’s domestic DVD business was a disappointment as it continued its slide in the fourth quarter as well. At the end of the quarter, revenue from the segment was down 31.3% year over year and 6.2% sequentially to $254.4 million. Total subscriber base slumped to 8.2 million. Despite the decrease, the company reported a slowdown in the rate of subscriber loss. During the quarter, Netflix lost 0.38 million DVD subscribers, which was down from 2.76 million subscribers it lost in the year-ago quarter and 0.63 million in the previous quarter.

Margins

Operating profit for the quarter was $19.6 million, down from an operating profit of $61.9 million in the year-ago quarter. However, sequentially, operating profit improved 21.7%. Operating margin declined from 7.1% in the year-ago quarter to 2.1%, due to higher costs.

Expenses were up 13.8% year over year, primarily due to higher cost of revenue (20.9% year over year), marketing expenses (2.7% year over year) and technology and development expenses (1.6%).

Net income for the quarter was $7.9 million compared with $35.2 million earned in the year-ago quarter. Decline in contribution profits in the DVD business and higher loss from the international business dragged the net income from the year-ago quarter. On a sequential basis, net income increased 2.6% driven by higher contribution profit from the domestic streaming business.

Though the reported EPS of 13 cents remained flat on a sequential basis it was well below the year-ago quarter EPS of 64 cents. The year-over-year decline in the earnings per share was due to higher costs and margin contractions.

Balance Sheet

Exiting fourth quarter 2012, Netflix had $748.1 million in cash and cash equivalents (including short-term investments) compared with $798.4 million in the previous quarter. Long-term debt remained at $200.0 million at the end of fourth quarter 2012.

Cash used in operating activities was $16.2 million in the fourth quarter of 2012, while Netflix reported a negative free cash flow of $51.0 million for the quarter.

Guidance

For the forthcoming quarter, management forecasts EPS to be between break-even to 23 cents. Net income is expected to be in the range of break-even to $14.0 million.

Domestic and International streaming revenue is expected to be in the range of $633.0 million-$641.0 million and $132.0 million-$144.0 million, respectively. Domestic DVD revenue is expected to be in the range of $239.0 million to $246.0 million for the first quarter of 2013.

Management expects total subscribers in the domestic streaming market and in the international streaming market to be in the band of 28.5 million to 29.2 million and 6.6 million to 7.3 million, respectively. The U.S. DVD subscriber base is expected to be in the range of 7.6 million to 8.05 million.

Recommendation

Netflix reported a better-than-expected quarter on the back of higher subscription additions. Although Netflix’s subscriber base increased considerably in the reported quarter, margins continued to remain under pressure due to higher expenses. We believe that Netflix’s effective cost management will dictate the company’s future prospects.

Moreover, new streaming content additions [recent deal with Walt Disney (DIS) and original program portfolio] will help the company to counteract stiff competition from other service providers such as Amazon (AMZN), HBO and Verizon (VZ). However, the company’s continuous subscriber loss in its DVD business and mounting losses from international business are major concerns going forward.

Currently Netflix has a Zacks Rank #3 (Hold).

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