Netflix Inc.

##Symbol##NFLX

Netflix (NFLX) reports earnings on Wednesday, 7-15-2015, after the market closes and I don't think it's going too far to say that it's one of the top five most anticipated technology earnings reports this quarter (throw in Twitter and Apple and you have a nice triumvirate). We'll discuss the particulars of what's expected (exactly), but first we must review why Netflix is priced to perfection, and why it has surpassed perfection to essentially an absurd level.

I expect an explosive response in the stock. If Netflix misses revenue or reduces forecasts of future revenue, the stock could totally collapse. If Netflix beats subscription forecasts and continues its margin expansion domestically, the stock could explode up.



Netflix is the apotheosis of technological disruption and may be the best company in the world at it. The firm has broken everything. Its competitors underestimated it, then copied it, then fell to their knees to help it turn save their TV shows. It accounts for nearly 37% of peak period downstream Internet traffic in the US. Yes, it's more than "one-third of the Internet." I'm going to show you incredible, then show you simply impossible, and then discuss the risks associated with earnings. Let's start with incredible, and then I'll show you impossible.

Here is a summary of the fundamental factors driving the 5 star rating. NFLX revenue, and free cash flow are at all-time highs, smashing each prior record every quarter. At the same time, the company is spending more on R&D than ever before.


The 41 analysts surveyed by FactSet expect Netflix to report total revenue of $1.65 billion. That breaks down to $1.02 billion in domestic streaming revenue, $457 million in international market revenue and $164 million in revenue from the domestic DVD segment (Source: )

Risks and Rewards
Netflix management has been rather consistent in their claim that margins inside the U.S. are (and will continue to be) rising. In a rather stunning outcome, while management anticipated a 2% growth in margins per year, in the April earnings call the company delivered 3.7% year-over-year margin growth. The company has openly claimed a domestic contribution margin goal of 40% by 2020, but if margins continue to increase faster than anticipated, the stock could move up huge if that 40% all of a sudden sounds like a conservative number.

The firm now has 41.4 million domestic subscribers and has given a wide ranging 60-90 million long-term goal. If we see subscriber growth slow to the point where the low end looks more like the number, the stock could fall massively. I'll address rather myopically it's expansion outside of the United States shortly. First, a little time travel.



On December 9th, 2013, Time Warner, the owner of HBO, CEO Jeff Bewkes stated clearly that HBO and Netflix aren't competitors. Of course they were. They competed for content, for subscribers and now they compete for viewers on a global scale. John McDuling aptly pointed out back then that Bewkes was either delusional or in denial.

It's now the "other guys" that are scrambling to change their modes of operation to keep up with Netflix. Time Warner has created HBO GO, which soon will be a stand-alone subscription web service. That's simply imitation; delusion and denial are over. Netflix made that decision for Time Warner.

Now Amazon.com's streaming service creates its own original content. That's a reaction, not a plan. Netflix made that decision for them as well and Amazon is possibly the single most dangerous technology firm on planet Earth. You can read that article here: Why Amazon is Growing More Powerful and More Dangerous.

Before we look beyond incredible and into impossible, the earnings estimates for next quarter along with last quarter's results are included below. Note, yet again, NFLX is estimated to break another all-time high in revenue.


According to a stunning RBC survey, 77% of US subscribers would not cancel the service if a $1 monthly price hike was introduced.

And here's impossible. The international market survey results are astounding, with over 85% of French and German respondents expressing "extreme" satisfaction with Netflix as viewership is rising at an accelerated pace in both markets. Netflix already has half as many subscribers, 20 million, internationally as it does domestically. Those are simply insane numbers. They're impossible numbers. And now 30 more countries are going to get their first taste of Netflix by the end of 2015. Netflix grew international subscribers 65% year-over-year per last quarter's earnings report. The bearish thesis here lies in a possible slowing international economy and Alibaba and Baidu's entrance in to the Chinese market as Netflix imitators. China may very well be simply out of the picture.

Netflix has broken a new record for revenue TTM every quarter since going public. That's over 50 consecutive quarters. The firm is outpacing its own stated goals for subscriber growth, and while it continues to spend heavily on R&D and SG&A relative to its past, those expenses appear to be well worth the cost.

NFLX is up +54.9% over the last three months and up +106.7% over the last six months. The stock price is up +53.6% over the last year.

Let's look at a two-year stock chart with regression channel and 10-day momentum on the bottom.


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Revenue over the trailing-twelve months has increased for 50 consecutive quarters, breaking a new high each time.

NFLX's fundamental five star rating benefited from these results:
1. The one-year change was positive.
2. The one-year change was greater than +20%, which is an extra boost to the rating.
3. The two-year change was positive.
Finally, the 50+ consecutive quarters of an upward trend in revenue benefited the fundamental star rating.

Let's look at the remarkable time series of revenue TTM US$ Millions in the chart below.


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Before we turn to earnings and cash flow analysis, let's look at a different view of revenue on a scatter plot with peers for some perspective. On the x-axis we equal space the companies and on the y-axis we plot revenue TTM per employee in $millions.



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Netflix generates $2.4 million per employee which is larger than any company in all of technology including AAPL. This is starting to get ridiculous, but it's real. These are objective measures of fact.



Net Income over last year for NFLX rose 46% coming in at $237 million up from $163 million a year ago. The quarterly number was lower given the expenses incurred to grow internationally, but I do note, the number was still positive. Netflix is going to sacrifice a bit of earnings now for more growth and earning sin the future. This is where the risk thesis lives. If Netflix misses revenue or reduces forecasts of future revenue, the stock could totally collapse. The market has been violently punitive to growth firms that miss forecasts; see Twitter as example A1.

In our next chart we plot net income TTM US$ Millions in the blue bars and the quarterly results in the gold line. Note the rising bars from a year ago and the dip in the gold line.



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It's not just earnings and revenue that are moving but free cash flow as well, which is up 17% year-over-year and ~60% over two-years. In fact, levered free cash flow has broken a new all-time high for 20 consecutive quarters. That trend too may suffer, so Netflix better hit that revenue number and not bring down forecasts.

Let's look at the visualization of FCF through time, below.



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Research and Development has broken a new all-time high for ten consecutive quarters. The costs make sense given Netflix's venture into Europe but note that they are well under control as we can see so clearly with rising free cash flow. Expect to see this number rise, combined with selling, general and administrative (SG&A) expense. These will impact earnings and free cash flow, but, again, a blow out revenue number makes all of this worth it (a lot).

In our final time series chart we plot Research and Development in the blue bars.



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Summary
The bullish thesis for Netflix is simple: Netflix has broken everything. It has killed all of its competitors' attacks and created such a large new industry that massive technology companies (like Amazon) are entering while old school media are hurrying to do it themselves (like Time Warner/HBO). Netflix announced a movie franchise with Brad Pitt. Netflix is the giant. New players emerged with the backing of Netflix's content competitors and now everyone is simply copying Netflix. And now the impossible is happening; growth and acceptance internationally seem like they very well may surpass domestic sales sooner rather than later. Margins are increasing faster than anticipated domestically and if that is coupled with hitting subscription growth forecasts, that's a truck load of money to the firm.

The bearish thesis for Netflix is based on a weakening European economy, a strong dollar (which hurts all of the numbers reported by Netflix other than the actual number of subscriptions) and ultimately a break-even point internationally that does appear to be way higher than that in the U.S. Further, the company's stated goal of 60-90 million domestic subscribers could suddenly feel closer to the low end if growth declines and that could be a catastrophe for the stock.

The bottom line is, if Netflix misses revenue numbers, it could be a blood bath, which ultimately, based on the past, might just be a buying opportunity. But if Netflix hits and exceeds revenue and subscription growth numbers and continues on its path to increased domestic margins, my goodness, this company could be worth $50 billion in market cap in a matter of months. Make no mistakes, the risk in this earnings report is gigantic.