Quick Thoughts: Netflix Fiddles while Traditional TV Begins to Burn

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–          NFLX beat on EPS ($0.86 vs. $0.81 consensus) and new subs (4M net adds vs. 3.85M guidance), as its original content strategy is beating on-line and traditional rivals alike.

–          With the rapid expansion NFLX subs and streaming hours, the contention that traditional TV viewing remains unaffected is not credible, an omen of future pressure on TV advertising.

–          Investors cheered the decision to raise prices for new subs, one of many unused monetization levers available NFLX – the $ will fund more original programs, new markets and higher margins

–          Despite cutting a well-publicized deal with Comcast for better interconnection, NFLX was explicit in its criticism of the proposed merger with TWC and of the market power of ISPs in general.

Netflix handily delivered another great quarter, maintaining momentum and delivering strong subscriber growth globally. US streaming subscriber additions were 2.25M, in line with management guidance, while international net adds beat the 1.6M guidance by nearly 10%, bringing total subscribers to more than 48M worldwide, up more than 25% YoY. The user growth drove sales in line with consensus expectations, while EPS of $0.86 easily topped the $0.81 forecast. While the results were unequivocally strong, the nearly 7% after hours pop came from CEO Reed Hastings’ abrupt about face on raising prices. After delivering upside to margins in this quarter, perhaps Netflix is starting to care about its profitability.

After years at a $7.99/month price point, Netflix will begin to ask its new subscribers to ante up an additional $1-2, with the implication that it will eventually look to transition its existing subs to the higher price point as well. The price increase comes at a time when the business is becoming more profitable with scale. Operating margins were up to 7.7% for the quarter from 5.3% last year. The domestic streaming business drove more profitability as contribution profit from the segment was 15.8% of revenue versus 12.8% last year. Strategically, investment in new content is critical to both attract new subs and keep existing ones, especially as other streaming services unveil their own original content. Amazon and Hulu both started bankrolling the production of originals after Netflix. Microsoft will join the party this summer when it will debut several live action series including comedy sketch shows from Sarah Silverman, Michael Cera, and Seth Green, a sci-fi series and a reality show about soccer to coincide with the World Cup. Netflix is not stopping, and is continuing to fund subsequent seasons of its most popular content including:  House of Cards, Orange is the New Black, Hemlock Grove, and Derek. It is also launching more new shows across genres, leveraging its exclusive distribution relationship with Dreamworks in the case of Children’s content, and it secured digital rights for  content in international territories near US release windows. Netflix still has a couple levers to fund new content it has not yet explored. Aside from raising prices, the company could begin to offer ad-supported or branded content. While ads interrupting customers binging on Breaking Bad or House of Cards may be viewed as disruptive, it could creatively deliver pre-roll ads or offer content funded by sponsors with product placements. An obvious element missing from Netflix has been video on demand, which services like Amazon or Apple have offered for at least the past 5 years.

Netflix has also been investing and succeeding in growing its international presence with those subs up 77.6% YoY and ex-US now making up 26.2% of all subs. The company is also poised to enter France and Germany, two of Europe’s largest, but also most operationally difficult markets in the fall. France in particular has stringent local content requirements. While multichannel and pay-TV penetration is lower abroad than in the US, Netflix has also been aggressively putting its app on European set-top boxes, which customers have embraced. It continues to make its streaming app available on almost every device capable of displaying streaming internet video. The company is planning to roll out set-top box integration in the US later this quarter.

Netflix made no secret of its struggles with US ISPs, notably Comcast and AT&T’s U-Verse. Its long term ISP performance index showed marked improvement in streaming for Comcast customers, which would have been expected after it agreed to pay Comcast for interconnect. Despite this, Hastings is adamantly opposed to the Comcast and Time Warner merger without significant regulations promoting net neutrality. Hastings notes NFLX has some 100 interconnect agreements globally. None of these though include AT&T, where measured speeds on video delivered via U-verse trail more antiquated and naturally slower DSL services. In its earnings press release, Netflix took a jab at what’s left of Ma Bell and challenged its management to agree to free and easy interconnection between AT&T and Netflix.

Netflix is aggressive and executing well. While guidance for next quarter suggests 1.46M sub additions, the company is poised to surpass that as apps linking to its service come standard on nearly every consumer video device and its content continues to receive critical acclaim. This quarter was a good one for investors. It looks like Netflix does care about earnings after all.

For our full research notes, please visit our published research site.

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