The Worst Thing About the Netflix Earnings Report

On Monday, Netflix reported third-quarter earnings, and the results were about as good as anyone could have hoped. Yet while the Netflix earnings report clearly exceeded expectations, it wasn't all roses.

The most concerning thing about the Netflix earnings report was the slow improvement in international profitability. While international subscriber growth beat the top of the guidance range provided in July, international losses increased sequentially. Furthermore, Netflix forecast a very modest reduction in international losses next quarter. This raises serious questions about when the international segment will start contributing profits rather than losses.

Unprofitable growth
International subscriber growth has been easy to come by for Netflix. By the end of the third quarter, Netflix had more than doubled the number of international subscribers year over year, from 4.3 million to 9.2 million. Paid subscriptions had also more than doubled, from 3.7 million to 8.1 million.

But Netflix's international operations are still nowhere near breakeven (let alone offsetting some of the company's overhead). On a sequential basis, the international loss widened from $66 million to $74 million, well within the guidance range for a contribution loss between $86 million and $70 million.

The uptick in international losses was the result of launching a new market last quarter: the Netherlands. This was the first new market launch since the fourth quarter of 2012, when Netflix entered the Nordic countries. When Netflix enters a new market, it must pay for an initial set of content and heavy advertising to promote the service. Since it's starting from zero subscribers, it takes a while for Netflix to build revenue to the break-even point in that market.

But this cannot explain the relatively weak earnings guidance for next quarter. At the midpoint of its guidance, Netflix will lose $65 million abroad next quarter. That represents a $40 million year-over-year improvement. Yet Netflix was incurring launch expenses in the four Nordic countries during last year's fourth quarter, whereas it has only launched one new market in all of 2013. (For reference, the Nordic countries together are about 50% more populous than the Netherlands.)

Long road to profit
While a $40 million year-over-year improvement in international losses next quarter would be better than nothing, at that rate Netflix will not hit breakeven internationally until 2015. Moreover, this calculation assumes that Netflix will not launch any new markets between now and then.

But Netflix is planning to launch in more international markets next year (and would presumably do so again in 2015). During the Netflix earnings interview, CEO Reed Hastings stated that the company is looking at some larger markets for 2014. While these probably have the biggest long-term opportunity, they also will have the highest start-up costs.

These start-up costs will slow or even temporarily reverse Netflix's pace of international loss improvement. Depending on how quickly Netflix adds new markets, this could push the international break-even date back by several years to near the end of this decade.

Foolish bottom line
Excitement about Netflix's international opportunity is clearly one of the major factors that has driven the stock up to roughly $340 as of this writing. For example, my colleague Anders Bylund thinks that the international segment should provide a positive contribution to Netflix's profit by 2016. He expects this to send Netflix stock to $600!

But if the Netflix fourth-quarter forecast is accurate, the company's international profitability is improving rather slowly, despite the fact that it launched only one relatively small market this year. If Netflix enters multiple large markets like France, Germany, or Japan over the next few years, it will take even longer to get to breakeven.

International growth could be a long-term win for Netflix even if it takes quite a while to reach breakeven. But time does matter in investing. The longer it takes for Netflix to reach profitability internationally, the less that profit stream will be worth today after being discounted to its present value.

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The article The Worst Thing About the Netflix Earnings Report originally appeared on Fool.com.

Fool contributor Adam Levine-Weinberg is short shares of Netflix and is long December 2013 $275 puts on Netflix. The Motley Fool recommends Netflix. The Motley Fool owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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