Shares of Netflix Inc. (NFLX) were up $14.18 (9.26%) after hours on strong third quarter 2010 results based on the fourth consecutive quarter of more than one million net subscriber additions.
Netflix gained significantly from an increasing demand for its streaming services. Moreover, introduction of streaming services in Canada also boosts its customer base during the quarter.
Earnings per share (including stock-based compensation) were 70 cents, up 35.0% year over year but down 12.5% sequentially. However, earnings per share were below the Zacks Consensus Estimate of 72 cents.
Revenue
In third quarter 2010, revenues shot up 30.8% year over year to $553.2 million compared with $423.1 million in the prior-year quarter. On a sequential basis, revenues increased 6.0%. This was slightly above the Zacks Consensus Estimate of $552.0 million.
This year-over-year growth was primarily driven by strong subscriber additions. Netflix’s total number of subscribers leaped 52.0% year over year, of which 94.0% were paid subscribers. The remaining 6.0% were free subscribers.
Net subscriber change increased 1,932,000 compared with an increase of 510,000 in the year-ago quarter and an increase of 1,034,000 in the prior quarter. Gross subscriber addition soared 88.0% year over year and 34.0% sequentially to 4,101,000 compared with 2,180,000 gross subscriber additions in the year-ago quarter and 3,059,000 gross subscriber additions in the prior quarter.
Subscribers who watched instantly more than 15 minutes of a TV episode or movie in the third quarter of 2010 were 66.0% compared with 41.0% for the same period of 2009 and 61.0% for the second quarter of 2010.
In the third quarter, churn was 3.8%, down 60 basis points to 3.8% compared with 4.4% in the year-ago quarter and 20 basis points compared with 4.0% in the second quarter of 2010.
Subscription acquisition cost decreased in the quarter to $19.81 per gross subscriber addition, as compared with $26.86 in the prior-year quarter and $24.37 in the second quarter of 2010.
Gross profit increased 41.3% year over year and 2.0% sequentially to $208.8 million. Gross margin was 37.7% in the third quarter, as compared with 34.9% in the prior-year quarter and 39.4% in the second quarter of 2010.
Operating income escalated 41.0% year over year but decreased 10.0% sequentially to $69.5 million. The sequential decline was primarily attributed to higher operating expenses, which increased 9.2% sequentially.
Balance Sheet and Cash Flow
As of September 30, 2010, cash and cash equivalents were $256.8 million as compared with $279.1 million at June 30, 2010. Long-term debt was $200.0 million, flat sequentially.
Cash from operations was $42.2 million in the quarter versus $60.3 million in the year-ago quarter. Free cash flow decreased to $7.8 million as compared with $34.2 million in the prior-year quarter.
Guidance
Netflix reiterated GAAP earnings per share guidance in the range of 59 cents to 74 cents for the fourth quarter. The company continues to expect GAAP net income of $32.0 million to $40.0 million.
Netflix raised its revenue guidance for the fourth quarter. The company expects revenues to be in the range of $586.0 million to $598.0 million, as compared with the previous guidance of $580.0 million to $596.0 million.
Netflix expects to end the fourth quarter with 19.0 million to 19.7 million subscribers, up from the previous guidance of 17.7 million to 18.5 million.
For fiscal 2010, Netflix projects GAAP net income in the range of $146.0 million to $154.0 million, as compared with the previous guidance of $141.0 million to $156.0 million. GAAP earnings are expected to be in the range of $2.68 to $2.83 per diluted share, as compared with a previous guidance of $2.58 to $2.86.
Netflix expects revenues of $2.15 billion to $2.16 billion for fiscal 2010, versus previous guidance of $2.14 billion to $2.16 billion.
Netflix plans to expand its services on an international scale in 2011. Management plans to invest approximately $50.0 million for such an expansion in the second half of 2011.
For fiscal 2011, Netflix expects to achieve 12.0% operating margin growth, based on strong demand from the North American market. Management expects to grow subscribers by over 50.0% year over year for fiscal 2011.
Partnerships
During the quarter, Netflix signed an expanded license agreement with General Electric’s (GE) NBC Universal Domestic Television Distribution division. As per the terms of the agreement, Netflix subscribers will be able to watch movies and television shows from NBC television network and NBC Universal’s popular cable channels over the Internet for just $8.99 a month.
In late September, Netflix started an online streaming only service in Canada for $7.99 a month. The company is also planning to start a similar service in the United States in the near future (possibly fourth quarter of 2010).
During the quarter, Apple Inc. (AAPL) launched an upgraded Apple TV device for streaming video to television sets. Apple also signed an agreement with Netflix, under which the latter’s streaming video service will be added to Apple TV.
In the third quarter, Netflix entered into an agreement with studio-owned pay TV service EPIX. The company has already added approximately 1,000 new titles from Paramount, MGM and Lionsgate through this new deal.
We believe these partnerships with NBC Universal and Apple will prove beneficial for Netflix over the long term as it plans to expand its streaming portfolio. The partnerships are expected to boost Netflix’s customer base in the United States.
Our Take
The robust third quarter results reflect Netflix’s increasing focus on becoming a streaming-only company over the long term. Although Netflix does not have any planned strategy to close its DVD distribution centers in the near term, we believe the company will eventually do so over the long term. We believe this will save significant distribution costs in the long term.
We also remain optimistic about the company’s international expansion strategy (possibly in 2011) after its successful Canadian launch in the third quarter. However, Netflix needs to have a strong streaming portfolio to attain success in the international market.
We believe Netflix needs to constantly monitor potential opportunities to enter into partnerships with big Hollywood studios and cable companies to maintain a diversified and upgraded catalog that will boost its streaming offerings over the long term. Netflix’s availability on both Apple TV and upcoming Google TV will boost its customer base over the long term, in our view.
Despite being nascent currently, we believe the online movie and television market will be a fragmented market over the long term, due to low entry barriers and declining DVD usage. Netflix continues to face tough competition from Amazon Inc. (AMZN), Apple and Google Inc. (GOOG) as well as cable providers in this market.
Netflix also continues to face stiff competition from Movie Gallery Inc. (MVGRQ) and Red Box, the kiosk company owned by Coinstar Inc. (CSTR) that rents DVDs for $1.00 per night.
We maintain a Neutral rating on a long-term basis (6-12 months) due to this increasingly competitive market and lack of visibility regarding Netflix’s international expansion strategy. Currently, Netflix has a Zacks #3 Rank, which implies a Hold rating on a short-term basis.
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