Your Cheat Sheet to Netflix Beating Earnings on Expanding Profit Margins

Netflix (NASDAQ: NFLX) yesterday reported what I would be hard-pressed to call either a miss or beat, yet they did not meet traders’ expectations.  The company reported $0.80 of earnings per share compared to analyst estimates of $0.71 per share; however revenue came in a bit light at $519.8 million compared to estimates of $524.4 million. For the next quarter, Netflix sees EPS of $0.74 compared to expectations of $0.68 per share.

Investors have come to expect beats from Netflix, as this has been one of the strongest stocks in the entire market since breaking out of long term resistance in March of 2009 as the broader indices were only then bottoming–that surely was an indicator of some upside to follow.  Many have been questioning both the value and growth potential of Netflix considering the company’s exposure to changes at the post office, as well as questions over competitors; however, those questions miss one of the fundamental shifts taking place in media consumption.

To me, the most interesting component of Netflix’ second quarter earnings were their margins.  Gross margins checked in at 39.4%, well above the 34.1% in the same quarter a year ago, and nicely higher than the 1st quarter’s 37.8%.  These margins shed some light as to why the company so handily beat earnings estimates, while missing on revenues.  The primary catalyst for this divergence sheds some true light on where Netflix future growth will come from: many more Netflix subscribers are now using the service primarily for streaming content as opposed to watching the by-mail DVDs.  Streaming is a much higher margin business for Netflix and is clearly the wave of the future for the company. Moreover, the company has been engaged in aggressively pursuing deals with studios to increase the volume of their streaming content library.

At this point in time, Americans have a nearly insatiable demand for “on-demand” and personalized content. With Netflix taking over the digital distribution landscape via devices such as the X-box, Playstation 3, the Roqu, etc, they are simultaneously improving their profit margins and creating an entirely new mechanism through which consumers can watch media and most importantly they are the first, most prominent, and best positioned to succeed in the space.  With the rapid uptake of mobile media consumption via the iPhone and Android-based, and now the iPad, Netflix is in prime position to benefit from this robust new market.

Anecdotally, I am fairly new to Netflix. I am not a big movie buff by any stretch and when I watch movies I do so from the comfort of my couch as opposed to visiting the theater. What inspired my subscription to Netflix was the availability of a nice chunk of their library via the digital distribution mechanism. For the most part, I am a high margin subscriber to Netflix and am looking forward to continued growth in the digital domain of the service. I infrequently engage in the Post Office based Netflix services and yet still pay the same monthly fee as one who is a manic mailer of DVDs.

These earnings provide a little ammunition to those who have been harping that Netflix is an overpriced stock since its parabolic ascent begin.  However, while this might put a dent in the stock’s short-term momentum, the company continues to both grow and evolve to better position itself in a dynamic media environment.  Second quarter earnings provide a clear glimpse into where the future of earnings growth is for the company, despite what appears to be slowing revenue growth.

Netflix short-term momentum takes a hit following this earnings release.

Disclosure: No positions.

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