Netflix Inc. (NFLX, Financial) operates as an Internet subscription service company that provides subscription service streaming movies and television episodes over the Internet. It majorly operates in three segments – Domestic streaming, International streaming and Domestic DVD. The company reported its third quarter earnings on the October 15, and the results were not very impressive. The stock market also reacted to the announcement and resulted in about 20% drop in stock price in after-hours trading. So, why the third was quarter such a disappointing one that nearly sank Netflix in the stock market. Let’s get into the quarter details to derive the answer.
A quick look at the number mix
Revenue stood at $1.41 billion, a 27.4% increase from that of last year’s similar quarter. The revenue was up 5.1% from that posted in the second quarter of the fiscal year. 25% of the revenue was earned through international sources, and the revenue generated through domestic sources went by 25.1% as compared to last year’s third quarter.
However, the revenue generated from the domestic DVD business line saw a dip of 16% on a year-over-year basis.
The contribution profit improved by 400 basis points, mainly due to the 50.7% increase in contribution profit from domestic sources. Net income also saw a lift from $32 million reported in third quarter of 2013 to $59.3 million in the same quarter of 2014. In terms of earnings, this translated to around $0.96 per share in the quarter.
Analysts were expecting earnings of $0.91 per share on revenue of $1.41 billion, and the top and bottom line met their expectations.
But there were certain signs which could move the earnings to the red, if not taken care of. Also, the guidance for the fourth quarter is dim from the management end. And there is competition coming up as well. Let’s get to these points in the upcoming section.
The decline in subscriber additions
Even though both revenue and profits were in line with analysts’ estimates, domestic streaming subscriber additions fell significantly short of the company’s guidance. As per the guidance subscriber additions domestically were expected to be around 1.33 million and internationally around 2.36 million additions were projected. However, the results stated a different story with domestic subscriber additions standing at 0.98 million and internationally the figure stands at 2.04 million.
One of the likely reasons for such a prominent decline in subscriber additions could be attributed to the price increase which has deterred new users subscribing to Netflix’s service. There are cheaper options available in the market such as Amazon (AMZN, Financial) Prime and Xfinity (CMCSA, Financial) Streampix. Even the management cited the price increase behind this slowdown in subscription noticed in the third quarter when Netflix increased the base price of the video-streaming business to $8.99 a month, while rivals still offered at $7.99 a month.
However, the management remains optimistic and expects addition of nearly 4 million subscribers in the fourth quarter considering the recent expansion of Netflix in a number of large European markets of late. According to CEO, Reed Hastings stated in the earnings call with regard to subscriber growth – “We really have to feel our way along, quarter by quarter.”
Marginal risks remain apparent
Analysts have opined that there are valid cost-concerns for Netflix. As the company is on an investment spree for launching its service in additional countries in Europe, it is spending on the recent agreements with Internet service providers for interconnection fees. This may led to shrinkage in margins on a medium term basis.
Netflix’s total content obligations stood at a massive $7.25 billion at the end of last year. This figure has risen to $8.9 billion by the third quarter of 2014, and it is being expected widely that Netflix’s streaming content obligation could increase to 175% of the annual revenue earned this fiscal year. If we look into the absolute deficit, the figure can be seen growing from $2.89 billion at end of 2013 to $4 billion at end of 2014. On top of that, Netflix has fee agreements with service providers which could pose a threat to its margin. This is because for improvement of the streaming speed and for giving the user the best experience the company might pay more than required to ISPs to further improve speed which could have a toll on its margins.
The management have also taken a cautious stand primarily due to their launch of service in six European markets newly in September, and has issued fourth quarter guidance which is much below current expectations. Indeed, the company is expecting to report an operating loss of $95 million for the international segment during the upcoming quarter.
Final conclusion
While Netflix has been able to meet analysts’ predictions for the quarter, it will have to focus on such intricate issues which can create pressure on its growing top and bottom line. Only then can its expansion in Europe bear fruit by improving the revenue and profit chart of the company in the upcoming quarters.
