Netflix Earnings Preview: 5 Things to Watch

Subscription growth, international markets and programming costs will weigh on the bottom line
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Netflix will report its second quarter earnings later Wednesday, following an incredible run-up in its stock price this year that has seen its share price more than double from $341.61 on Dec. 31 of 2014 to $702.60 on July 14.

Netflix now ranks as the best performing stock on the S&P 500 in the first half of this year, per the Wall Street Journal.

The company’s seven for one stock split, which will take on July 15 before the Q2 earnings report, could further boost prices by making it more affordable to additional investors and most analysts have been raising their price targets with generally positive reports. But as usual there are a number of contrarians, which the WSJ highlighted in an article called “Hot Netflix Not Ready for Its Close-Up.” It pointed out that free cash flow by non-GAAP measures has been negative over the last three quarters.

Both bulls and bears, however, agree in a few key factors that will weigh heavily on the stock’s performance following the Q2 earnings:

Subscriber Counts

The street consensus for the Q2 report is revenue of about $1.65 billion, higher than the $1.47 billion management has promised, and earnings per share of about $0.31. (Or $0.04, if Netflix reports it in terms of the stock split.)

Management has forecast $0.26 earnings per share.

The big metric though will be subscriber counts. The 2nd quarter has traditionally been a slower one for Netflix and management is predicting about 2.5 million net additional subs, fewer than the 4.88 million adds reported in Q1 of 2015.

Netflix is predicting only 600,000 net additions from the U.S., down from about 2.28 million in Q1. But management believes that international growth will increasingly compensate for a slowdown in the increasingly crowded U.S. market.

International Markets

The saturation of the U.S. market, where the company hopes to hit nearly 41 million paid members in the Q2 report, means that its aggressive international expansion will be closely watched. Netflix is predicting it will have 21.50 million paid members with 1.9 million net ads in Q2 outside the U.S. That marks significant growth over a year earlier in Q2 of 2014, when it had about 12.9 million paid members.

But international net adds will drop from the 2.28 million seen in Q1 of 2015.

Rapid international expansion has however cut into profits, producing negative free cash flow and significantly reducing operating income. Netflix is predicting about $59 million in operating income in Q2 of 2015, down from $130 million in Q2 of 2014.

That will make any announcements about further international expansion into countries like China important both for maintaining subscriber growth and for reduced profits.

Programming Costs

The most bearish argument against Netflix has long been rising programming costs.

Proponents of that view hasn’t slowed the company’s rapidly rising stock price. But those costs remain a major question mark, particularly as Netflix buys more international rights and ramps up its original programming.

At the end of the first quarter, streaming content obligations hit $9.8 billion, up from $7.1 billion at the end of Q1 in 2014.

The company points out that this increase of 31% is in line with the growth in streaming revenue, which grew by 31% year over year from Q1 2014 to Q1 2015.

But the increased costs highlight the importance its original programming, which has been expanded to include a controversial movie slate.

Netflix remains determined not to release any real data on viewing but a string of duds could renew criticism of those costs.

OTT Competition

Much of Netflix’s success with investors has been based on the idea that consumers will give up multichannel TV subscriptions for its OTT service.

So far, traditional pay TV subscriber losses have been miniscule—around 0.1 to 0.3% in the last two years. In fact, management has long maintained that the two offerings are complementary and it continues to work to expand the availability of the Netflix offering on traditional pay TV operators like Dish and Atlantic Broadband.

Worries about a stagnant multichannel TV business have, however, encouraged many programmers to launch their own OTT subscription offerings and convinced some operators like Dish and Comcast to launch their own bouquets of streaming services.

Those offerings, which have only been in the market a short time, are unlikely to have much of an impact in the second quarter. But competitors like Amazon and Hulu continue to invest heavily in new programming and in the longer term, the trend towards wider usage of OTT services could actually produce some challenges for Netflix.

If cord cutting accelerates, programmers would likely seek to make up lost revenue from cable, satellite and telco providers by expanding their OTT offerings and by charging Netflix more for their shows, which in turn could hurt profits and increase competition.

Either way, the OTT market is likely to continue to fragment, making it harder for Netflix to maintain such a dominant share.

Price Increases

That raises the longstanding question of when Netflix will increase prices. Management has insisted that they are comfortable with current pricing. But the company’s success after its last increases indicates that it may still have more headroom in raising subscription costs or carving out new tiers.

That ability to bump up prices could give Netflix some breathing room that would protect it from rising costs and increased competition, at least in the next few years.

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