Netflix Gains Altitude, Clears Clouds of Confusion


Netflix (NAS: NFLX) came into Wednesday's fourth-quarter report with a dark cloud of unanswered questions hanging over its head. The report and analyst call cleared away a ton of that confusion. Did CEO Reed Hastings cover all the bases? Let's dig in and find out.

By the numbers
In terms of meeting expectations for the quarter, Netflix did that and more. Analysts were looking for about $0.54 of earnings per share on $857 million in revenue. More importantly, they wanted to see somewhere in between 20 million and 21.5 million domestic streaming customers. Netflix is a business fueled by customer counts, not classical earnings.

Netflix delivered $0.73 of earnings per share on $876 million in sales, blowing away those gloomy analyst estimates. The 47% year-over-year revenue jump is roughly in line with the trend throughout 2011, so this shouldn't be a great surprise. The Street clearly expected the new pricing plans and the Qwikster brouhaha to take a heavier toll than they really did.

And then there's the subscriber count. As you might expect from the big revenue number, this metric came in strong, too. Netflix now boasts 21.7 million domestic streaming subscribers, 23.5 million streamers globally, and 26.3 million unique subscribers overall.

Share prices jumped as much as 22.4% in early trading. Investors are loving these numbers.

DVD versus streaming
You'll notice that I didn't discuss DVD rentals much in the general overview. That's because the division becomes less important to Netflix with every day that passes.

Yes, DVD shipping provides the lion's share of the company's operating income today, and the 52% profit margin seems impressive.

One analyst pressed Hastings on why he won't put some effort into keeping this cash cow alive. And the key to that equation is, the variable cost of streaming services is close to zero. Content delivery specialists Akamai Technologies (NAS: AKAM) and Level 3 Communications (NAS: LVLT) take a small cut per gigabyte of data delivered, but nowhere near the massive costs of buying, handling, packing, and shipping DVD discs. Bits and bytes are extremely cheap.

"So actually, it's the opposite, which is the profitability of a new streaming subscriber, the contribution margin is almost twice what it is for a DVD subscriber," Hasting said. Doubling a 52% margin is impossible, but it should be clear that additional streaming accounts are essentially pure profit in the bank no matter how much they use the service.

The only real cost of running the digital service lies in content licenses, which is why Netflix pushes so hard to sign new content deals. If you build it, they will come -- and the more we're there together, the happier Netflix's profits will be. Without compelling content, those customers will just go rent a DVD or watch pay-per-view instead.

"We'd like to have someone use both services because, obviously, that's both more revenue and more profit," Hastings elaborated. "But if they were only going to use one, we'd much prefer them use the streaming service." And that's why Netflix is leaving the DVD to wither under the spirited assault by CoinStar's (NAS: CSTR) Redbox service. It's no skin off Hastings' nose. And no, there will be no video-game rentals in red envelopes. That idea died with Qwikster.

International plans
Hastings has made it clear that his international expansion plans are on hold for a while. It costs money to expand into new territories, chiefly in the form of fresh content deals and starting-from-zero marketing campaigns. The first quarter will show a loss thanks to expansion costs in the just-launched Irish and U.K. markets. So the next territory will have to wait until Netflix is profitable again.

But that won't necessarily take years. CFO David Wells clarified that the profit target is on a quarterly basis, not annual. Netflix expects to post a loss for the 2012 fiscal year, but the company underestimated its own growth in the fourth quarter. If that's the new trend (post-Qwikster), the next overseas market could show up before the end of the year.

Who's your daddy?
Netflix sees HBO as its main long-term competition. Hastings estimates that the Time Warner (NYS: TWX) service gets around $7 to $8 of monthly fees per subscriber from the cable and satellite guys. If Netflix can reach a much larger subscriber base than the premium cable network, Hastings says, "that will allow us to spend even more on content and have an even better service."

In addition, Netflix has more experience with a personalized on-demand service, which looks like another selling point. But them's fighting words. Expect the HBO rivalry to only heat up even more as the years go by.

Foolish takeaway
After this morning's dramatic jump, share prices have now climbed 78% from November's rock-bottom levels. It only took one nice report to clear out a whole mess of investor worries. I fully expect the good news to keep on coming, powered by international success and a return to rapidly rising digital streaming numbers.

2011 will soon feel like a bad dream (or a good one, if you took advantage of low share prices to build your position). You know, like that time Blockbuster seemed certain to kill Netflix with the hare-brained Total Access idea. If you bought shares near that market bottom, you just spiffy-popped this morning. These are just speed bumps on a long road to global success. My friend Rick Munarriz sees Netflix reaching 30 million global customers in 2015. I'll pick up that glove, Rick -- try 50 million.

Add Netflix to your Watchlist so you can see the story develop. This would hardly be the first American company to dominate a global market. Netflix is walking down a well-travelled path.

At the time thisarticle was published Fool contributorAnders Bylundowns shares of Netflix but holds no other position in any of the companies mentioned.Motley Fool newsletter serviceshave recommended buying shares of Netflix. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinion, but we all believe that considering a diverse range of insights makes us better investors. Check outAnders' holdings and bio, or follow him onTwitterandGoogle+. We have adisclosure policy.

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