Netflix Earnings Preview: Eye on Subscriber Numbers

Netflix (NASDAQ:NFLX) will release its Q2 2014 earnings on July 21, and we’ll be keenly watching the trends around its subscriber metrics and contribution margins. While the overall customer base will continue to grow, the rate of growth is likely to come down compared to the last year due to the greater impact of seasonality. Netflix’s content superiority and device reach have been the primary drivers behind its success, and that’s unlikely to change anytime soon as the company continues to invest in original and exclusive content. The real meaningful debate should be around its market valuation, which even from an optimistic point of view, looks a little steep. Here is what you can expect from Netflix’s second quarter earnings.

Our $281 price estimate for Netflix stands at a discount of about 35% to the market.

See our complete analysis for Netflix

Greater Impact of Seasonality on Domestic Subscriber Growth

Netflix expects to gain roughly 0.52 million domestic streaming subscribers in the second quarter of 2014, which is substantially below the figure of 2.25 million that the company saw in the first quarter. ^[1] This is not unexpected as Q2 tends to be seasonally weak. However, the impact of seasonality will be visible more this year due to bigger subscriber base, which will essentially translate into higher number of disconnects. In Q2 2013, Netflix gained roughly 0.63 million domestic streaming subscribers. Considering this in mind, the expectation for Q2 2014 implies a year-over-year decline. Since Netflix has stopped reporting certain metrics like churn rate, it is difficult to assess whether this decline will be primarily due to the higher impact of seasonality or a slowdown in gross subscriber additions. Most likely, it will be a combination of both.

Expect Close to 1 Million Net International Streaming Subscriber Additions

Netflix currently has more than 13.6 million international subscribers in Europe, Canada and Latin America. Quarterly international subscriber additions peaked in Q4 2013 and came down slightly in Q1 2014 due to seasonality. In Q2 2014, the company expects to gain just short of 1 million subscribers internationally, thus registering a significant sequential decline. This, again, can be attributed to seasonality but the intensity of the impact will be less considering a relatively small international subscriber base and increased growth momentum in recent quarters.

Netflix recently decided to expand into additional markets in Europe in late 2014, which should help it consolidate its international business. This expansion could push quarterly net additions to as high as 2 million. This would lead to a negative impact on profits in the short term, and international losses are likely to increase. However, given that Netflix’s current international operations are nearing profitability, it makes sense for the company to take some risk and consolidate its position in the international market.

Margins Are Likely to Improve

Netflix’s contribution margins will improve both sequentially and year-over-year in domestic as well as international markets. The primary driver behind this improvement will be growth in subscriber base resulting in fixed content costs spreading over a larger revenue base. In addition, there may be the mild impact of the recent price increase. The company has raised the monthly price for its streaming service in the U.S. by $1, and made a somewhat similar adjustment to its international streaming plans as well. However, the increased pricing will apply only to new customers whereas the current subscribers will continue to pay the same price for two years. Overall, our analysis shows that Netflix can add roughly $500 million in annual incremental revenues in the U.S. alone by 2017 with this move.

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1. Netflix’s Q1 2014 Letter To Shareholders [↩]