Entertainment Analyst: A Deeper Look at Netflix Earnings

According to analyst Michael Pachter at Wedbush Morgan, Netflix (NASDAQ:NFLX) was going to face unprecedented rising costs. He was right.

Here’s a summary of Pachter’s recap of Netflix earnings:

Q1 revenue growth was driven by subs growth and price increases. Revenue was $719 million, compared with our estimate of $715 million, the consensus estimate of $704 million, and guidance of $694 – 717 million. Netflix ended the quarter with 23.6 million subscribers, compared with our estimate of 23.7 million, guidance of 22.65 – 23.7 million, and 20.0 million subs at the end of Q4.

Profitability was in-line with expectations as gross margin upside is offset by higher SG&A. EPS was $1.11, compared with our estimate of $1.13, the consensus estimate of $1.07, and guidance of $0.90  – 1.13.  Gross margin exceeded expectations due to the long lead time associated with content deals. SG&A higher than expected as company increased marketing spend.

Netflix (NASDAQ:NFLX) again provided limited 2011 guidance. Initial Q2 guidance is for revenue of $778 – 798 million, ending subs of 24.9 – 25.85 million, and EPS of $0.93 – 1.15. Netflix maintained guidance for a domestic operating margin of  ≈ 14% for FY:11, and for a positive operating margin for Canadian operations in Q3:11. For 2H:11, Netflix lowered guidance for operating losses for international operations to ≈ $50 –70 million from ≈ $50 million. Looking forward, streaming content costs are expected to rise significantly, while DVD shipments and marketing should decline.

Maintaining our 2011 estimates for revenue of $3.22 billion and EPS of $4.00. Initiating our 2012 estimates for revenue of $3.96 billion and EPS of $5.00.

We expect  streaming content costs to increase by at least $500 million in 2011. We estimate that the cost of streaming content deals has risen from around $180 million in 2010 to a likely case of $1.975 billion in 2012. Netflix (NASDAQ:NFLX) has not confirmed financial terms of studio deals, but it is clear that streaming costs will rise significantly in the near future, more than offsetting declining fulfillment, marketing, DVD purchase and postage expenses.

Maintaining our UNDERPERFORM rating and our 12-month price target of $80, which reflects 20x our FY:11 EPS estimate of $4.00.  This multiple is at Netflix’s expected long term earnings growth rate to reflect positive execution.

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