Quick Thoughts: Netflix’s Quarter – If you build it… they will watch


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–           NFLX Q2 sales were on target and EPS beat, but failing to hit 30M US subscribers and cautious Q3 guidance triggered a sell-off after the odd streaming video earnings call.

–           The success of NFLX’s original content had driven sub expectations beyond guidance in a seasonally tough quarter, when NFLX had also suffered the loss of Viacom’s kids programs.

–           Management touted its original programs, citing strong internal metrics and its 14 Emmy nominations. New exclusive and original content deals are in the works.

–           As we have written in our 4 part “War on TV” series, we are in the early days of the shift to on-line video – NFLX is in position to be one of the biggest winners in the next era.

Earnings continue this week with yet another near miss in tech with Netflix reporting 2Q 2013 after the bell today. NFLX has been the star of the S&P 500 this year, up a stratospheric 182.9% YTD. It wasn’t that long ago in 2011 that the company bungled the separation of its streaming and DVD by mail businesses, losing subscribers and sending the stock from nearly $300 per share in July 2011 to sub $60 a year later. From that nadir, Netflix began beating the drum with strong sub growth and the well-received debut of its exclusive and original programming. With expectations running hot after two straight quarters with more than 2M new US subs, the 630K net ads in 2Q13 were not quite enough for some investors, particularly since they missed the psychologically significant 30M total US subscriber threshold.

NFLX marked 2Q 2013 with a departure from the norm by offering a 30-minute earnings interview moderated by CNBC’s Juila Boorstin and BTIG’s Rich Greenfield rather than a traditional earnings call format. For analysts, the new format was strange as there was an absence of CEO/CFO statements and the company dove right into a moderated interview session with questions aggregated from investors, sell-side analysts, and even other media companies. The new format makes it more difficult to get a question answered unless it’s identified as relevant by the moderators, though some believe visual cues from company executives could be telling. While the session opened with an open ended question on subscriber numbers directed toward CEO Reed Hastings, the moderators did exhibit some tenacity probing for insights and numbers around subscriber behavior and plans for further original content programs.  Not surprisingly, Hastings & Company revealed little during the call, though some nuggets did emerge: viewers typically watch 90 minutes of content daily translating to nearly 1.4B total hours a month, NFLX original series are seeing TV sized audiences, and the company defines hits as any shows it would decide to renew based on internal subscriber metrics. The implication is that if something gets picked up again, it was likely a hit. As the company has a subscription driven model, ratings don’t matter but “membership happiness” does.

While the earnings interview gave little indication of what drove subscriber numbers during the quarter, I have my suspicions. First, the second quarter running from April 1 to June 30 is a peculiar time for programming television content. While much of the country experiences warmer weather, traditional TV still brings out the big guns as the first run broadcast TV season come to an end with May TV Sweeps and live events like the start of baseball season and the NBA/NHL playoffs garner respectable viewing figures. NFLX has a lot to compete with during the quarter. Second, rights to valuable children’s programming from Viacom lapsed, and shows like SpongeBob Squarepants, Blues Clues, and Dora the Explorer were picked up by Amazon in a multiyear exclusive deal. Such programming is a draw for many households with children. Chief Content Officer Ted Sarandos was mum when asked about the impact of such shows. NFLX did sign deals with Disney and Dreamworks for other kids programming, but neither has a stable of shows that were as popular.

Longer term, a quarter or two of slower subscriber additions shouldn’t be too much of a worry. According to SNL, more than 53M US households are equipped with devices able to stream video from the internet to their television. With 56% penetration into these households, NFLX has plenty of further runway, particularly since we expect many more connected households in the future, with consumer electronics that will make it considerably easier to find and watch on-line content. Furthermore, Netflix has a small beachhead presence in several international markets, and should be able to generate considerable international growth down the line.

Last week’s Emmy announcements were also a major win for Netflix. Though it already won an Emmy last year for a technical category, these nominations are the first for original web-based programming. While NFLX only has 14 nominations compared to HBO’s 100+, “House of Cards” received 8 nominations including Outstanding Drama. It was only in 1999 that HBO’s Sopranos was the first non-broadcast program to be nominated in the category. “House of Cards” only premiered in February and was NFLX’s second attempt at an original series. Original content seems to be paying off so far, but others have taken notice. Amazon committed $1B to exclusives and originals, while Hulu trails at $750M in similar commitments, but neither has yet earned an Emmy nomination, which is critical to gaining credibility with audiences. All in all, while it was not a remarkable quarter for NFLX in terms of exceeding investor expectations, it was its best top-line quarter to date and reflects that its strategies are paying off.

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

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