Netflix Q4 2012 Update

Exclusive Update

For longtime Netflix (NFLX 1.51%) bulls such as myself, vindication is sweet, isn't it? As I write this the Friday afternoon following Netflix's 2012 fourth-quarter earnings release, shares are trading at $168, up 14.4% the day after shares rocketed upward more than 42% following that earnings release. 

Subscriber growth and predictions:
Looking at the midpoint of guidance for this quarter given at the end of last quarter:

Overall, the result beat guidance midpoint by 3%.

I've got data for seven full years now, and management has missed only four times over those 28 quarters, with results averaging a beat of midpoint of guidance by 1.4%. That's an incredible record.

For Q1, management is predicting 2.1 million added domestic streaming subscribers, 1.4 million added international streaming subscribers, and 0.17 million fewer domestic DVD subscribers (all at midpoint), for 43.63 million total. This would represent sequential growth of 8.3% and year-over-year growth of 22.2%.

Data is king
Everyone says that "content is king," usually in preparation for bashing Netflix for not having all the content the speaker wants. However, I think that Netflix is proving that data is what's really king. There was a recent article in The New York Times that speaks to this very point -- chief content officer Ted Sarandos, when he heard about the remake of House of Cards, went and investigated the data Netflix had collected and discovered that material starring Kevin Spacey or produced by David Fincher was popular, political thrillers were popular, and the original production of House of Cards was popular. That led him to snap up the rights to the new House of Cards.

I'm convinced that this is just one example of many times where data is used to drive licensing deals. As I've written here, this gives Netflix a huge advantage over competitors because it knows what content is truly worth using the only metric that matters: viewership. Others don't, as demonstrated by all those shows that appear and then disappear on television every single year.

I believe it's also going to drive more and more original programming from Netflix, letting the company get rights to some fantastic series. Maybe management can even start mining the data and suggesting series to various directors or actors or writers rather than waiting for something to be proposed. If they do that and are successful at it, that could be a real game changer for them. (This is speculation on my part, however. Maybe directors, actors, and writers wouldn't want to be pitched ideas based on data mining like this.)

New paradigm
The company spent quite a bit of time, both in the release and a bit on the call, about the new paradigm for watching TV. With Netflix and others, you don't need to be tied to a specific time on a specific day to watch content. And you don't have to do it week after week, consuming a story piecemeal. They likened it to reading one chapter of a book a week versus the whole thing. (Of course, newspapers used to serialize longer stories before they were released in book form back in the day.) This gives people a lot more flexibility and control over what they watch and when.

On the downside, I remember getting together with some friends every week for a few years, having dinner together and watching Star Trek Next Generation and then Deep Space Nine. Good times. I suppose people will adapt, though, maybe having series-binge viewing parties.

Note that this new paradigm also gives the content creators a lot more flexibility and freedom. Regarding the new House of Cards, show runner Beau Willimon said, "We approached this creatively as a 13-hour movie. ... Knowing we had two full seasons in advance, I didn't feel the pressure to sell the end of each episode with superficial cliffhangers or shock tactics in order to keep [viewers] coming back, in order to jack up the ratings week to week."

New debt raise
This came as a bit of a surprise, for me, at least, but I believe it to be a smart move. The debt markets are currently offering long-term debt for really low rates. If Netflix can issue 20-year bonds at just a few percentage points of interest, that's almost certainly worth doing. I remember hearing recently that one company even issued a 100-year bond. Why not, if it's doable and the terms are agreeable? Seems as if it would be simple debt, no convertibles or things like that, which is better. Note that this will not include any stock offering or use of convertible debt.

DVD subs
Did you notice that the rate of drop is slowing? Since the company started breaking this number out, sequential declines have been:

There might actually be a lower limit to the number of DVD subs. Given that a lot of content is not available on streaming but is on DVD, this should probably not come as a surprise. In addition, not everyone has broadband Internet, so streaming is not an option for everyone.

This was touched upon at a couple of points in the call, too. First, management said that today's subscribers are more sophisticated than earlier ones. That is, when streaming first started, people thought it would be like the DVD library -- everything available all the time. It wasn't, and this is something that I think Netflix still is dealing with. But today's subscriber is more aware that licensed streaming content is more restricted. This came up in the discussion during the Q&A conference call about higher voluntary retention rates (people choosing to stay subscribed, something companies using a subscription model keep a close eye on).

The other comment that touched upon this was that marketing seems to be picking up for the DVD side, at least given the fact of some email marketing recently. That's a result of tests being done on things like saves. If somebody searches for something and doesn't find it available for streaming, that person might receive an email saying it's available on DVD and they might consider subscribing to that service. Here's what Hastings said: "It was incrementally positive to our DVD subscriptions and we faced a lot of criticism 12 to 18 months ago that we weren't doing enough in terms of monetizing some of the failed search opportunities on the DVDs, on the website and so forth, and I think we've cleaned a lot of that up."

Original content
During the call, there were many questions about this, trying to find out how much the company plans to spend, what kind of subscriber boost would be seen, will it work, etc. Most of the answers were along the lines of, "It's too early to tell." Management did say that they'd revisit the issue in the call for Q2 in July, after they've had a chance to see how House of Cards and Arrested Development perform. But basically, reiterating comments from earlier conference calls, if the original content does at least as well as other exclusive content they get relative to the cost, they'll keep on paying for this. And given the depth of their data, they can measure that pretty well.

Best comment
To set this up: If you remember last year at this time, Hastings said that they expected to gain 7 million new domestic streaming subscribers in 2012. When they had to admit that they wouldn't in the Q2 call (I believe), the stock price got hammered pretty severely.

In response to an emailed question on 2013 profitability and margins, CFO David Wells said something about seeing leverage in the new plans with the caveat that international expansion decisions for the second half of 2013 haven't been made yet. (In other words, the company will probably be more profitable if they don't move into another international market this year.) Then Hastings chimed in, saying that they have 7 million reasons not to give predictions this year.

Well, I thought it was funny.

One last thing
As fellow Fool Rick Munarriz pointed out, what Netflix has been doing recently has convinced at least one long-term bear, Janney Montgomery Scott analyst Tony Wible, to change his mind and actually upgrade the company. Hopefully that will be the first of many upgrades for Netflix.