Quick Thoughts: NFLX 2Q14 – In Line is the New Upside Surprise

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–          Media reports can’t seem to decide whether NFLX’s 2Q14 beat consensus or not, but it counts as an upside surprise anyway, because new subscriptions beat forecasts handily

–          US net sub adds were 570K, and Int’l was up 1.1M, collectively beating guidance by more than 14%, right after a price increase and in NFLX’s most challenging seasonal quarter.

–          NFLX’s recent Emmy nomination bonanza and European push should help keep the momentum for 2H14, with guidance implying revenues above the current $1.38B consensus

–          Management expects Int’l to lose $42M in 3Q, due to investment in Europe, putting EPS guidance well below consensus. Given the strong sub growth, this shouldn’t be a red flag.

Thomson Reuters says the analyst consensus for Netflix 2Q14 EPS was $1.16. FactSet says it was $1.14. Netflix decided to split the difference, reporting $1.15, and sending the news wire into a whirlwind of conflicting articles. The Wall Street Journal main site reported the miss against the Thomsen numbers, while the same company’s MarketWatch and MoneyBeat reporters went with the beat. Both sources of consensus estimates agree that Netflix revenues of $1.34B were in line with expectations, so perhaps, all together, it’s safest to call the quarter in line. Except, the stock isn’t reacting like the news is quite so “meh” – it was up more than a percent in after hours after trading up 1.75% during the regular session and after having risen more than 40% in just the past 2 months. It seems that Netflix delivered an upside beat, whether Thomson Reuters thinks so or not.

The key number is streaming subscriptions. In its previous earnings release, management had predicted 520,000 new U.S. subscribers for the quarter – it delivered 570,000. In foreign markets, management had predicted 940,000 new subs – it delivered 1,100,000. Overall, the total new streaming subscription additions were 14.3% higher than had been promised, in the first quarter after Netflix had risen prices for new subscribers by  12.5%, during the company’s traditionally slowest seasonal period, bringing the total number of Netflix subscribers above 50M for the first time in history. Apparently, an additional dollar a month is no deterrent – a year ago, 2Q13 subs were up 3.4% QoQ, a tick below this year’s 3.5% sequential growth.

For a stock whose valuation is entirely predicated on investors’ expectations of future growth, the subscription story is a powerful driver. A bigger Netflix, with more subs and higher prices, can afford to buy and develop more and better programming, which in turn, will bring more new subs and allow even higher future prices. This self reinforcing cycle is turning before our eyes – Netflix snagged 31 Emmy nominations for this past season, with both “House of Cards” and “Orange is the New Black” gaining nods for best series, best lead actor and best lead actress in their respective categories. The growing buzz around these series has undoubtedly been a big factor in the impressive sub numbers that the company continues to post.

Those impressive sub numbers are, in turn, the drivers of Netflix’s also impressive 25% revenue growth – with a future boost from that sneaky price increase. Management’s guidance for 6.8% sequential growth in 3Q14 streaming revenues is probably conservative, implies a significant acceleration from last year’s 5.6% QoQ streaming sales growth, and suggests substantial upside vs. consensus forecasts of less than 3% sequential revenue growth.

As for 3Q14 earnings guidance, management is explicit in its plans to ramp up investment both in programming and in opening new markets, particularly in Europe. This translates into a (-$42M) projected contribution from the International segment for the quarter, and for overall EPS of $0.89. This is well below the analyst consensus of $1.06, but given Netflix’s track record in turning investment into growth, Investors seem to be giving management the benefit of the doubt.

Count me in as a Netflix bull. I believe that there is substantial further subscriber growth and additional price increases to come. I also believe that Reed Hastings will, eventually, backtrack on his pledge not to offer an advertising funded alternative, opening yet another avenue of monetization. Beyond that, Netflix could also be a future venue for additional subscription tiers, for live programming, and for other lucrative pay per view services. There is a lot more here than just $7.99 a month.

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

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