5 Highlights From The Netflix Earnings Report

Netflix is starting to look like a precision machine. The company modestly exceeded expectations for the fourth quarter, adding 2.3 million subscribers in the U.S. and more than 4 million overall, bringing the total to 44 million worldwide. It is predicting a similar result for the upcoming quarter, but there are challenges ahead. For one, the company has concerns about a recent ruling overturning net neutrality rules that could potentially put it at a disadvantage. In the meantime, Netflix plans to continue experiment with pricing, though that doesn’t mean a rate increase is imminent. Finally, looking down the road, the company’s financial position has some challenges. Here’s a drill down on what we know:

Net neutrality effects are likely to be minimal — for now

CEO Reed Hastings certainly didn’t seem happy that the FCC’s rules requiring ISP to treat all content equally are no longer in effect. But importantly, he also didn’t seem too worried. “There’s some draconian scenarios where some ISPs drop Netflix,” Hastings said. “[But] the most likely scenario in the near term is that there’s no change.” Hastings had two critical points that ring true: (1) Any move to harm Netflix and other video services would “significantly fuel the fire for more regulation.” Netflix now has nearly 1 in 4 U.S. households as customers. That’s a lot of people to complain to their congresspersons. (2) Netflix is a win for ISPs.

Most of the cable and telco ISPs are in the midst of sorting out exactly how much speed and  bandwidth they will provide each month at different prices, but one thing is clear: Big Netflix users are most likely to buy the more expensive plans. In much the same way ExxonMobil currently has no incentive to make life difficult for owners of gas-guzzling SUVs, ISPs currently don’t gain much by making like hard for Netflix users. Of course, that could change.

BTIG’s Rich Greenfield, who moderated the call, suggested ISPs might very slowly turn the screws on Netflix. While he didn’t specify how, one could imagine very small charges placed on very big bandwidth users — Netflix is responsible for 30% of U.S. peak internet traffic. Over time, if Netflix found itself paying more to get you their service, they might have to increase prices to cover those costs. In the meantime, though, Hastings sees things staying much as they are on price…

New tiers might be coming

… except as concerns some small tweaks to what Netflix currently offers. Today, streaming customers choose between $7.99 for 2 simultaneous streams or $11.99 for 4. The company has tested a $6.99 plan with one stream in standard-definition only and apparently has run other tests. Asked whether cutting $1 off the price mattered, Hastings said. ”We’re probing around the edges. In going from 33 million members to more than twice that, every bit of savings (matters).”

He described the company as seeking a “good, better, best” model, which is common in lots of consumer products and a new Netflix philosophy of willing to sacrifice a little bit of simplicity to find the right offerings. “It’s not clear one price fits all,” Hastings added. That means we can expect to see a third price sometime soon, once Netflix is done testing. And it will almost certainly be differentiated by how many people can watch on the account at once and possibly video quality. What won’t happen is a “premium tier” that includes more/better content.

Hastings essentially ruled that out explaining that anything licensed by Netflix as a differentiator would have to be exclusive and, as such, would only make sense economically if everyone got it. So forget “Netflix Plus More Movies”; it’s not happening. Similarly, existing customers shouldn’t worry about getting an overnight price increase. Any change will come with a grandfathering period for existing customers, though how long is unknown.

Commercials aren’t coming to Netflix

With the suggestion that Netflix is now popular enough people would tolerate some limited commercials, Hastings was unequivocal. “We have no plans for going to advertising-based models. It’s not something we’re contemplating,” he said. Ted Sarandos, the company’s content chief pointed out that the whole Netflix experience has become about the ability to just sit and watch, whether it’s one episode or a whole season. Forcing you to wait through some ads is anathema to that. He added that current Netflix licensing doesn’t allow them to run ads on most (all?) of their content and that it would cost more to do so. It seems safe to say that not only aren’t ads coming anytime soon, they aren’t coming unless the service is radically overhauled.

DVD still matters a lot to Netflix, but it’s demise continues

Because it isn’t sexy, there weren’t many questions about the company’s DVDs by mail business. But we know a couple of things from the company reports and they are both fascinating and concerning at the same time. First, the total number of customers receiving red envelopes is down to 6.9 million. That’s a substantial drop from  more than 8 million as of April. If that rate were continue in a straight line, the DVDs by mail business would disappear in a bit over four years. But who cares?

On the next page: A look at some warning signs ahead

Well, investors ought to. The “contribution margin” — Netflix’s financial measure of the business — from DVD was $110 million in the quarter, just slightly below the $117 million the streaming business generated worldwide. There are some important notes about that figure. First, Netflix expects DVD to matter much less. In the coming quarter, it’s expected to deliver just $98 million, while streaming is being looked at for $156 million. Second, if we exclude international streaming — which is currently a money loser as it ramps up — domestic streaming is expected to be twice as profitable going forward as the DVD business. Third, somehow the DVD business is delivering as much margin today as it did 9 months ago with those extra million-plus subscribers.What this suggests is that an increasing portion of the remaining DVD customers are “zombie accounts” who don’t use the service much or at all. A similar phenomena occurred at AOL when it stopped requiring people to pay for dial-up internet. Some people just never canceled (believe it or not, some still haven’t!). There is little doubt many Netflix DVD customers remain quite active, but the strong financials on the weak customer numbers suggests that Netflix will continue to get a boost off DVD for a while.
Financial factors

That boost is going to matter given that despite Netflix’s strong performance, it remains somewhat thinly capitalized. The company added just $5 million in free cash last quarter against $48 million in earnings. To fund new programming, it plans to take on $400 million of debt in the coming quarter while interest rates remain low. That will bring Netflix’s total to $900 million which the company sees as low from a debt-to-equity perspective but means “net cash” on the balance sheet will essentially be zero. Furthermore, Netflix continues to account for programming obligations off the balance sheet and those have ballooned to $7.3 billion from $6.5 billion.

That increase was expected. The company has expanded deals with Marvel, Dreamworks, Sony, et al. But it should give people pause. The stock exploded after hours and is flirting with $400 per share against an earnings consensus of around $4 for the coming year. While Hastings fretted a bit about the stock price last quarter, he brushed aside concerns this time around even though they seem more paramount.

None of this is to suggest that Netflix is in imminent danger of trouble, just that it’s incredibly pricey at 100 times forward earnings. The company still believes it can grow its U.S. business by tens of millions and perhaps it’s correct. But that’s a multi-year process and those content costs move from off the balance sheet onto the income statement in the meantime. More flawless execution like in the past quarter will be required going forward.

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Source: Forbes