Netflix Earnings Preview: Strong Topline Growth Accompanied By Cost Concerns

Netflix (NASDAQ:NFLX) will report its Q3 2014 earnings on October 15th and we expect the company to report strong revenue growth.  Key drivers will include new subscriber additions and the mild impact of price increment it implemented earlier this year, in our view. On the flip side, margin growth may slowdown as a result of incremental investment in the international segment. Additional costs due to interconnection fee agreements with Internet service providers may have a small impact on profitability as well. Considering these factors, we believe that investors should exercise some degree of caution while assessing Netflix as an investment. Let’s take a look in detail regarding what to expect from the upcoming earnings.

Our price estimate for Netflix stands at $315, implying a discount of about 30% to the market.

See our complete analysis for Netflix

Revenues Will Find Support From Domestic And International Growth

Netflix is likely to see strong topline growth driven by domestic and international subscriber additions.

Last quarter saw greater than usual impact of seasonality on Netflix’s subscriber growth. Although the company gained 0.57 million domestic streaming subscribers compared to its initial expectation of 0.52 million, there was a sharp sequential as well as a slight year-over-year decline in the figure due to seasonality. Since Netflix does not report its churn rate, it is difficult to assess whether this decline was primarily due to the higher impact of seasonality or a slowdown in gross subscriber additions. We believe that it was a combination of both as Netflix’s is likely to have cycled through majority of broadband houses in the U.S. The impact of seasonality will fade away in the third quarter and we expect strong sequential growth as well as slight year-over-year increase. The latter will be driven by Netflix’s investment in several original series focused on kids during the third quarter. The mid point of guidance suggests that the company added somewhere around 1.33 million domestic streaming subscribers during the quarter.

International business is another story. The market potential is huge in Europe and Latin America, and Netflix has just begun to tap into it. The company launched its services in some additional countries in Europe in mid September, and the impact will be better visibility in its fourth quarter results. With this expansion, Netflix is now present across 12 countries in Europe with a combined population of close to 270 million. If we include Canada, Netflix’s international market potential rivals that in the U.S. This does not include Latin America, which we believe is likely to remain a small contributor to Netflix’s international revenues in coming years. Besides leveraging its brand, the company is relying on its tie-ups with European network providers. It recently struck deals with biggest telecom operators in France, which will make Netflix available on set-top boxes of their customers, thus giving the company an instant access to around 12 million users.

Margin Growth May Slow Down Slightly

Given Netflix’s investment in content related to its launch in additional countries in Europe, its spending on original series and its recent agreements with Internet Service Providers for interconnection fees, we believe that margin expansion may lose some steam. International operations are still unprofitable and it may take a while for Netflix’s revenues to cover the incremental costs of expansion. That’s not necessarily disturbing as long-term benefits from this investment far outweigh the short term margin pressure. However, spending on original content and newly added expenses related to interconnection fees must be carefully scrutinized.

Netflix’s total content obligations stood at a massive $7.25 billion at the end of 2013, amounting to 166% of annual revenues. Considering the figure at the end of first half of 2014, and the fact that Netflix would have invested disproportionately more in international markets in the third quarter, we believe that these obligations could reach as high as $8.5 billion by the end of 2014 or 158% of expected 2014 revenues. While this suggests that revenues are growing faster than content obligations, the decline in the percentage figure is not as much as one would hope for. If we see the absolute deficit (obligations minus annual revenues), we see the figure growing from $2.89 billion at the end of 2013 to $3.1 billion at the end of 2014.

Additionally, Netflix’s recent interconnect fee agreements with service providers raise an alarm. The company has reported notable improvement in its streaming speed and user experience after these agreements, but the speeds are still not as good as in several European countries. This suggests that domestic ISPs may charge further for speed improvement, and this could weigh on Netflix’s margins going forward.

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