Netflix Earnings Analysis: Content Squeeze is Inevitable

Netflix (NASDAQ:NFLX) Q4:11 earnings beat driven by better-than-expected subscriber growth and domestic contribution margin, as well as low marketing spend. Revenue was $876 million, compared with our estimate of $869 million, consensus of $858 million, and guidance of $841 – 875 million.  EPS was $0.73, compared with our estimate of $0.61, consensus of $0.55, and guidance of $0.36 – 0.70.

Q4:11 subscriber growth was ahead of our expectations. Netflix had 24.4 million unique domestic subs (we estimated 23.85 million), including 2.73 million DVD only subs (we estimated 2.55 million), 8.44 million hybrid subs (we estimated 8.60 million), and 13.23 million streaming only subs (we estimated 12.70 million).

International expansion and increased content spending to drive net losses for the year ending December 31, 2012. Netflix guided to a net loss for FY:12 and modest losses for each quarter of the year. In addition to losing 9 million highmargin DVD subs over 2H:11, Netflix will likely have to increase marketing and content spending by 25% for the UK and Ireland alone, hurting profitability.

Netflix is understating the impact of losing Starz (NASDAQ:LSTZA) on the quality of streaming content. Netflix described the remaining content available for streaming under the deal as fifteen Disney Pay 1 (NYSE:DIS) titles and Encore catalog titles, dismissing the Disney content as constituting only 2% of domestic viewing, and the Encore content as easily replaceable. We disagree with Netflix and view the Disney movies as some of Netflix’s most desirable streaming content, and the Encore content as a diverse catalog that enhances the depth of the streaming offering.

The loss of Starz reflects the difficult trade-off between content quality and content costs that Netflix currently faces. Netflix has to make a choice: either it will have high subscriber growth due to high-cost,  high-quality content, meaning profits will be small or nil; or it will have lower subscriber growth due to low-cost, low-quality content, meaning it will make money but not be a growth story. In our view, the high-growth, high-profit story is not going to happen.

Maintaining our UNDERPERFORM rating and 12-month price target of $45. Our price target reflects 15x our FY:13 EPS estimate of $3, a level of earnings we view as attainable once Netflix has lowered international spending and revised its pricing structure. Our multiple is in-line with the company’s long-term growth rate.

Michael Pachter is an analyst at Wedbush Morgan.

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