DEEP ANALYSIS: Netflix Earnings EXPOSED These Flaws

The following is an excerpt from a report compiled by Michael Pachter of Wedbush Securities.

Domestic streaming drives better-than-expected Q2 earnings.  Revenue was $889 million, compared with our estimate of $901 million, consensus of $889 million, and guidance of $873 – 895 million. EPS was $0.11, compared with our estimate of $0.03, consensus of $0.05, and guidance of $(0.10) – 0.14.  EPS upside came from additional contribution profit for the domestic streaming segment, lower international losses, and flat global operating expenses.

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Sustained profitability appears unlikely, as Netflix (NASDAQ:NFLX) continues to balance EPS and expansion. Although management expects profitability in Q3, a Q4 loss is expected as Netflix launches in another European market. The company articulated its strategy of alternating periods of expansion (losses) with periods of profitability, making sustained profitability elusive.  We expect Netflix to operate at roughly break-even until it has completed its international land grab later this decade.

Given management’s clear statement that profits would remain elusive, we expect consensus EPS numbers to decline significantly. We believe it is highly likely that consensus 2013 EPS estimates drop from $2.12 to under $1.00. At our $0.50 estimate, the stock closed yesterday at 160x earnings, and should consensus estimates drop to close to our estimate, we think that Netflix shares could trade to close to our price target in the coming weeks.

We continue to view full year domestic streaming net adds guidance as unrealistic. Netflix expects 2012 domestic streaming net additions of ≈ 7 million. With 1.74 million domestic streaming net adds in Q1 and 0.53 million more in Q2, Netflix must add approximately 4.73 million over the second half of the year to hit its target. This implies a 32/68 split between 1H and 2H, even more aggressivethan its historical 41/59 split.

Adjusting our FY:12 estimates.  Decreasing our 2012 estimates for revenue to $3.65 billion from $3.68 billion and increasing our estimates for EPS to $0.03 from $0.00 to reflect the Q2 beat and additional clarity around 2H.

Maintaining our UNDERPERFORM rating and 12-month price target of $45. Our price target is 15x our sustainable EPS estimate of $3, which we believe is attainable (albeit aggressive) only if Netflix forsakes growth at all costs and raises prices. Our multiple is in-line with the company’s long-term growth rate.

Michael Pachter is an analyst at Wedbush Securities. 

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