Max Grigoryev
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Max Grigoryev in Fundamentality,

Netflix ahead of earnings

Netflix is going to announce its Q2 results next Monday after the closing bell. I've already reviewed the company's financial and operating metrics and therefore I want to make my own forecast of the company's financials. As far as my analysis is based on unit-economics and important operating metrics, here is a summary from my previous post about Netflix:

  • Netflix burns their cash on so called international expansion;
  • Netflix doesn't report retention rate and churn numbers, hence we don't see the whole picture of their business;
  • competition with Amazon Prime is tough, Amazon proved that the quality of their content could be better.

Financial and operating metrics in Q1 2016

High quality financial models should be based on the unit economics, it shows the business trends: how the company generates leads, how it converts them into clients, how much it costs for the company to get 1 paying client on board etc. Netflix isn't an exception. During Q1 2016 Netflix showed the opposite trends for its domestic and international business:

  • Netflix increased the number of paying memberships for domestic streaming from 41.4k to almost 47k and which is more important increased domestic streaming Average Revenue Per Account from $23.78 to $24.72 (3.9% growth);
  • The company increased the number of paying memberships for international streaming 20.9k to 34.5k, but they were not able to increase ARPA and it dropped from $19.9 to $18.9 representing a 5% fall;

Netflix's management likes to show positive numbers a lot, that's why they showed the following table in their 10-Q report:

As you can see, the global streaming memberships went up 31% which is a strong positive number. However, the major part of their growth is coming from their international expansion. A 13% of its growth was generated domestically, while their international streaming members increased by 65%. As far as the company is losing its losing its money through this international streaming services, which number do you think is more important: 13% domestic growth or 31% overall growth?

Financial and operating metrics in Q2 2015

In order to see the company's trends and check if Netflix business is exposed to season's factor. According to the company's information, during Q2 FY2015, Netflix added 903k memberships for domestic streaming services and 2,374k to international streaming. During 2015 fiscal year the company was actively expanding its business to the new regions, but as we've already seen, international streaming is unprofitable for the company at the moment. Almost 2.4M of new members were added due to this international expansion which is definitely a fake international expansion. Netflix is trying to posses themselves as a global company but they are paying a huge price for that. 

According to my calculations based on the company's data, during Q2 FY2015 the company had a positive operating margin for domestic streaming division. Per each membership the company earned around $8 in the United States (revenue without cost of revenue and marketing expenses). However, for the international streaming services it was the same situation as we've already checked in Q1 2016 - the company lost (I prefer "lost" rather than "spent" because of a few reasons which I will describe later on) almost $4 per each international customer. If we compare average revenue per unit (paying customer, membership), domestic streaming finished Q2 with $24.25 ARPA, international streaming for the same period reported $19.6 ARPA. 

Next step is defining the growth rates (Q2 FY2015 vs Q1 FY2015). Netflix increased its domestic streaming revenue by 4.2% and international streaming by 9.5%, however, the cost of revenue increased as well: 5.2% for domestic and 12.7% for international. Basically it means that gross margin is narrowing for both divisions. Despite the fact that cost of revenue increased, the company was able to decrease its marketing expenses for domestic streaming - Netflix spent 18% less on marketing in Q2 FY2015, but at the same time they spent 18% more on marketing for international streaming. 

Operating margin per each member sightly increased for domestic (around 6%) and dropped almost 30% for international going into deep minus zone. 

Forecast

The first number that I'm going to estimate here is number of memberships. As soon as the company keeps getting more and more international members, I think it will show up to 57-62% growth in international streaming memberships in Q2 FY2016 compared to Q2 FY2015. So the company will report from 36,504k to 37,677k memberships. As for domestic streaming, the company will have a limited 12-14% growth. So I think that total number of domestic memberships will be in a range of 47,376k-48,222k. 

The second part is defining ARPA growth rates and forecast potential average revenue. I assume that Netflix will be able to keep its small growth in ARPA. I think this growth will be around 4-6% (compared to Q2 FY2015) and ARPA for domestic customers will reach $25.22-$25.7. ARPA for international streaming services will drop 5-7% and will be around $18.18-$18.58. 

Top line domestic streaming revenue will be from $1,194M to 1,239M, while international revenue will reach $678M-$685M. Both ranges are very narrow, but the company didn't changed the business significantly, so the main assumption is that it keeps its business trends in Q2 FY016. 

The main question that worries me is their international expansion. As I've already told, I consider it as a fake expansion due to a number of reasons. First of all, local competition. Netflix is trying to get as many markets as they only can, but there are a number of local players on this markets and it will be really tough to get in. You can say that they have a high growth rate in international memberships, but do you know the retention rate? Perhaps they lose a lot of customers and get more due to huge marketing expenses. This international expansion is very limited and at some point of time we'll see the descending trend in total number of memberships if Netflix doesn't adapt its platform to the local needs. Second, they didn't even translate the system into the local language. They don't even work on getting more local content. And it's really important, that's why I call their international expansion - "fake". 

I don't want to make a forecast regarding target stock price because people simply love this stock. It means that it can go higher with no reason. I'd better take a look at their earnings and check an opportunity to trade options here.