Netflix (NASDAQ: NFLX ) earnings beats have become something of a regular occurrence since late 2012. On Monday, Netflix exceeded its own guidance and analysts' even rosier EPS estimates, yet again.
In the past year or so, Netflix's domestic streaming business has become its primary profit driver. However, improvements in the international business (i.e, shrinking losses), are helping domestic earnings drop to the bottom line. During the next few years, I expect international growth and profitability trends to be the most important driver of stock-price gains -- or losses -- for Netflix.
International: The source of Netflix's earnings beat
Back in January, Netflix provided initial Q1 guidance for a $24 million sequential improvement in domestic streaming contribution profit on 2.25 million net subscriber additions. Meanwhile, it expected a $15 million improvement in the international streaming contribution loss on 1.60 million net additions.
The domestic numbers came in right around Netflix's expectations. The company hit the nail on the head with its domestic streaming subscriber guidance -- it added 2.25 million last quarter -- and the domestic streaming contribution profit increased $27 million, slightly better than the guidance.
Most of the company's profit upside came from international markets. Netflix added 1.75 million international streaming subscribers, nearly 10% ahead of its guidance, thereby reducing its international contribution loss by $22 million sequentially.
Looking ahead, Netflix expects almost twice as many international subscriber additions as domestic streaming subscriber additions in Q2. As a result, Netflix projects that the international contribution loss will shrink by $23 million, compared to a $22 million streaming contribution profit increase domestically. This puts it on track to reach breakeven internationally by Q3.
The cost of expansion
Netflix may be closing in on the breakeven mark outside the U.S., but it is about to disrupt its international profitability. On numerous occasions in the last six months, Netflix has stated that it plans a significant European expansion later this year. This will lead to faster revenue growth, but it will create a significant drag on earnings.
Speculation about Netflix's European expansion has centered on France, Germany, and possibly Belgium. Recently, German media outlets reported that Netflix is likely to launch there in September. Just this week, Bloomberg reported that Netflix is on track to start service in France before the end of 2014.
It's virtually certain that expanding into these countries will bring another wave of red ink for Netflix's international operation. During the quarterly Netflix earnings interview this week, CFO David Wells suggested that Netflix's experience in the U.K. provides a good approximation of the investment needed to get similar-size markets up and running.
In the quarter that Netflix launched in the U.K. and Ireland, its international contribution loss spiked by $43 million sequentially. France and Germany combined are more than twice the size of the U.K. and Ireland combined. As a result, the impact on Netflix's quarterly international contribution profit could be as high as $100 million.
In other words, launching Netflix in France and Germany (and possibly Belgium) could offset two years of international segment profitability improvements. However, this is simply the price of building up a franchise from scratch in a new market.
What really matters for investors is how fast Netflix catches on in these countries. Netflix executives have refused to discuss individual market dynamics for the past couple of years, but it appears that, while all international markets are improving, some are stronger than others.
Clearly, Netflix sees an opportunity in continental Europe. However, it could still take two or three years -- or more, in a downside scenario -- to reach breakeven in France and Germany. The pace of Netflix's growth in these markets will have a huge impact on both the size of investment needed to reach breakeven and the return on that investment. That could be the difference between good and bad stock performance for Netflix.
Foolish final thoughts
For the last two years, improving domestic profitability and slower international expansion have worked hand in hand to drive rapid earnings growth at Netflix. The coming European expansion will disrupt this status quo. Whether that's good or bad for Netflix investors will depend heavily on how fast Netflix can bring its new international markets up to breakeven.
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