International Profit Improvement Is the Real News at Netflix, Inc.

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.

Netflix beat earnings estimates last quarter on the back of strong international growth.

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.

The high costs of acquiring content could lead to big initial losses in France and Germany.

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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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 23, 2014, at 6:51 PM, sj95135 wrote:

    Older HBO content going to compete with netflix! who wants that. HBO wants to make some money on some content which is older and no demand to play on HBO go.

  • Report this Comment On April 24, 2014, at 1:45 AM, sliderw wrote:

    Your article is music to short-term NFLX bears and long-term NFLX bulls.

  • Report this Comment On April 24, 2014, at 9:29 AM, pauldeba wrote:

    You forgot to add that in 16 years, Netflix has never made much money and probably never will make much money, but don't let that reality get in way of your fantasy.

    It's interesting to note how this France launch from Luxembourg has not met with skepticism from the brilliant analysts. Anyone that has done business in Europe knows that their approach is not viable from a legal, fiscal or regulatory perspective, which makes me believe that Wall Street has no idea how business is done abroad. The primary support is that "google and other techs have headquarters in Luxembourg and Ireland". The absolute ignorance of that comparison is astounding.

    I have to believe Netflix has a lot of impaired assets (content and taxes) and is not properly transfer pricing intellectual property and royalties to countries like Brazil, Colombia, Argentina and Chile. I'd love to see the auditor's workpapers.

  • Report this Comment On April 24, 2014, at 2:16 PM, Fo45 wrote:

    The only attraction and growth factor for Netflix was the originals and low subs price but with Amazon prime offering tens of HBO's award wining shows all as good or better than HOC there is no this original factor for netflix anymore.The price hike removes this "bang for the bucks" factor and will significantly affect growth. Net neutrality gone Netflix will be milked by ISPs. So, there is nothing to look forward to for Netflix but international growth which has been and will be a money loser for a few years. Furthermore, HBO is very popular internationally with more than 100 million subs so the deal between Amazon and HBO will seriously impact international growth.

    I would be cautious with the stock because dropping to below $100 is becoming more and more real with Netflix dipping after a good Q is a serious warning.

  • Report this Comment On April 24, 2014, at 2:23 PM, Fo45 wrote:

    Did I read right someone said that HBO will not be able to compete with Netflix? NO COMMENT!!!!!!!

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