Will Netflix, Inc. (NFLX) Continue to Grow?

Netflix, Inc. (NASDAQ:NFLX) reported a fairly strong quarter in terms of profitability. But the outlook on revenue wasn’t exactly hot.

Earnings highlights

Source: Netflix

For the most part, Netflix, Inc. (NASDAQ:NFLX) has been able to improve its contribution margin by 740 basis points year over year. So with membership profitability jumping by such a large margin, it’s no surprise the stock has been able to rally.

Analysts were anticipating the company would report earnings of $0.40 per share. The company reported earnings of $0.49 per share for the most recent quarter.

What is the stinker?

The issue with the earnings report had less to do with the company’s performance, but with the guidance that was provided for the next quarter. The company anticipates that the midpoint for subscriber additions is going to be 1.09 million for the third quarter; in the previous year period the company was able to add 1.16 million subscribers. Analysts are worried that the company’s rate of revenue growth is going to decline based on the guidance that was provided.

The company has been able to increase the amount of cash and cash equivalents to $1 billion, while long-term debt remains at $500 million. The company’s cash flow has been able to improve to $13 million. Solvency issues have been largely mitigated, but the net profitability of Netflix, Inc. (NASDAQ:NFLX) is still small.

The upsides

In the first quarter of 2013, Netflix, Inc. (NASDAQ:NFLX) reported a 0.26% net profit margin. Following that, in the second quarter of 2013, the company reported a 2.76% profit margin. Between the first and second quarter, the contribution margin improved from 20.6% to 22.5% (the contribution margin improved by 1.9% between the two quarters), this caused the net profit margin to increase from 0.26% to 2.76%.

Here’s the important part: The management team told investors that the contribution margin is likely to improve by 4% per year.

My best guess is that, because the company’s profitability will improve by 8-10% (two-years-out assumption), and net revenue is expected to be $5.07 billion by 2014, we can assume that profit margins could be in the 8% to 10% range. If that is the case, then earnings could be in the range of $405 million to $507 million by 2014. Currently, analysts are anticipating the company to generate $173 million in earnings by 2014 (approximate). If the company beats expectations in future quarters, the stock will continue to appreciate at really high rates.

The downside to this assumption, however, is if fixed costs were to go up at all, then there will be limited gains in profitability. The management team did not provide any guidance on fixed costs, so we’re sort of shooting in the dark.

Longer-term analysts on a consensus basis anticipate the company to grow earnings by 21% per-year over the next five years.

Microsoft Corporation (NASDAQ:MSFT) predicts that the number of internet users will grow to 4 billion. Netflix, Inc. (NASDAQ:NFLX)’s total addressable market will be significantly larger than its current subscriber base (meaning there’s a lot of opportunity for growth).

Does Amazon remain a serious threat?

Amazon.com, Inc. (NASDAQ:AMZN) in its most recent earnings report was unable to report a profit. The company’s lack of profitability is fairly understandable as the company has spent cash to aggressively expand.

Amazon.com, Inc. (NASDAQ:AMZN) Prime is estimated to have 10 million subscribers, according to Morningstar analyst R.J. Hottovy. The costs for running Prime are split between having to pay for the two-day shipping costs, and the content collection. The company’s capital spending is heavily focused on building data centers and international distribution centers. The company’s resource allocation is constrained by its retail and cloud activities.

Amazon.com, Inc. (NASDAQ:AMZN) with all of its resources hasn’t been able to catch up to Netflix, Inc. (NASDAQ:NFLX). Netflix started its streaming service in 2007, and in just six years has more than three times the subscribers as Amazon Prime. Sure, Amazon offered video streaming later on, but it doesn’t change the fact that Netflix has a competitive advantage over Amazon despite the sheer amount of resources that Amazon has.

The problem I have had with Amazon.com, Inc. (NASDAQ:AMZN) Prime is that it bundles movie streaming while lowering shipment costs for Amazon shipping. The two are largely incompatible with each other. While I understand that brand extension can work for certain companies (Apple Inc. (NASDAQ:AAPL)), it can also be argued that splitting services into different tiers (International Business Machines Corp. (NYSE:IBM)) can be more effective.

Amazon.com, Inc. (NASDAQ:AMZN) would have to triple the size of its user base to catch up to Netflix, Inc. (NASDAQ:NFLX); the company also has to pay up for both shipping and content costs. Some would argue that the cross-selling may be able to off-set costs, but I don’t really buy that theory, especially when considering Amazon is still unprofitable.

What about Google?

Google Inc (NASDAQ:GOOG) could be a considerable threat to Netflix, Inc. (NASDAQ:NFLX). YouTube recently released a service called paid channels. There are currently 60 channels (a small amount), but when considering the large user-base that YouTube currently has, paired with the amount of cash on its balance sheet, Google could become a serious competitor in the space.

The paid-channels service provided by YouTube has a lot of potential, as the price points for the channels are set at around $5 per month. The problem with YouTube is that the price points for these channels are high relative to what Netflix, Inc. (NASDAQ:NFLX) offers at $8 per month. YouTube is looking to offer an alternative distribution point for traditional TV broadcasting, which could lead to better profit maximization. The companies that could get hurt by this change in distribution are the TV channel providers like CenturyLink, Inc. (NYSE:CTL), Cox Communications, and DISH Network Corp. (NASDAQ:DISH).

Conclusion

The guidance indicates that Netflix, Inc. (NASDAQ:NFLX)’s management team will aim to improve profit margins by lowering the cost of acquiring subscribers. This may send mixed signal to analysts, but with YouTube aimed at a different target market, and Amazon.com, Inc. (NASDAQ:AMZN) far behind in subscriber count, the effects on long-term sentiment should be minimal.

I also believe that Netflix, Inc. (NASDAQ:NFLX)’s content library will remain superior to its competition as long as competitors pay an economically reasonable price for content.

The article Will Netflix Continue to Grow? originally appeared on Fool.com and is written by Alexander Cho.

Alexander Cho has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Google, and Netflix. The Motley Fool owns shares of Amazon.com, Google, and Netflix. Alexander is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

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