Netflix's Got Game After All

By Will Ashworth | January 29, 2013 AAA

Netflix (Nasdaq:NFLX) released its fourth quarter earnings results Jan. 23 after the close of trading. They were so good that the stock jumped a whopping 42% in the next day's trading. Netflix hasn't been this high since September 2011. On the news, a slew of analysts upgraded its stock with price targets upwards of $200. The good times appear to be back. Is it still a buy after the big move?

SEE: Analyzing Show Biz Stocks

More Subscribers
Netflix added more domestic streaming subscribers in the fourth quarter (2.05 million) than it has in quite some time. Its domestic streaming generated $589 million in revenue in the fourth quarter, a contribution profit of $109 million, and a contribution margin of 18.5%, 210 basis points (BPS) higher than in the third quarter. Internationally, its streaming business added 1.81 million subscribers, its highest addition in the past five quarters. All told, its streaming business now has 33.28 million subscribers worldwide. It's going to take a while, but I don't see any reason why Netflix can't get to more than 25 million subscribers outside the United States. Once it does, its profitability will substantially improve. Interestingly, Netflix suggested the first quarter would see contribution profits for domestic streaming exceed those of its DVD division for the first time in its history. It's a watershed moment for sure.

SEE: What's Next For Netflix?

Carl Icahn
Say what you will about the billionaire, but his call on Netflix was right on the money. Icahn accumulated his 10% stake in Netflix last October using a call option strategy that ultimately cost him an average of $58.41 per share. At the time of his filing, Forbes quotes Icahn as saying, "Netflix may hold significant strategic value for a variety of significantly larger companies that are engaging in more direct competition with one another due to the evolution of the Internet, mobile and traditional industry." In a nutshell, Icahn thought the shares were extremely cheap, especially to a larger company that could utilize its significant revenue generation to buy more content. Icahn says he's going to hang on to his shares, suggesting the company has "tremendous potential." With the shares jumping another 17% or so on Jan. 25, Icahn went into the weekend sitting on a paper profit of $626 million, which is an annualized return of 194%. He might say he's going to hold, but those kinds of profits are tough to resist.

SEE: The Greatest Investors: Carl Icahn

Content
Netflix detractors argue that with content acquisition costs getting higher all the time due to increased competition, there's no possible way for its business model to successfully transition to a profitable one. On the surface, I can appreciate this argument given costs appear to be rising faster than revenue. They are building a content library, however, that will have a little of everything: original TV series, first-run movies from Disney (NYSE:DIS) and others, and everything else in between. The more subscribers it gets, the bigger the budget it has for getting unique, exclusive content. That's one of the reasons Icahn bought in; he could see that no other competitor, Amazon (Nasdaq:AMZN) included, has anywhere near the leverage Netflix has. Eventually, the variety and quality of programming will neuter its competition.

SEE: Netflix Has A Crowded, Bumpy Road Ahead

DVD
Although its domestic DVD business experienced a loss of 380,000 customers in the quarter, it was much less than expected. With 8.2 million DVD subscribers, this business appears to be an annuity, one that will ultimately disappear but not before it's paid out significant profits. It lost customers in the fourth quarter, yet its contribution margin was 50.1%, 190 BPS higher than in the previous quarter. So, even though its revenues were $17 million less, its contribution profit was just $3 million lower. And as I said previously, it's expecting to generate contribution profits from its domestic streaming in the first quarter that are higher than the DVD business. The DVD might be dying on the vine, but by hanging in there a little while longer, it's giving the streaming business the time it needs to become the profitable business model Reed Hastings knows it can be. This modern version of the horse and buggy will turn out to be its savior.

The Bottom Line
Given the unpredictability of the content business, Netflix is going to have further bumps in the road. There's no way around that. Its ability, however, to generate content people want to watch, whether it's brand new or 50 years old, is what sets it apart from its competitors. I personally love the fact I can explore documentaries such as the "Inside Job," old episodes of "Breaking Bad" and the "The Rockford Files," new shows such as "House of Cards" and still be able to watch John Candy for the umpteenth time in "Uncle Buck," all in one spot, commercial-free, at one really low price.

Netflix has got game - more than anyone knew.

At the time of writing, Will Ashworth did not own any shares in any company mentioned in this article.

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