Netflix's Earnings Satisfy Growth and Momentum Investors

Netflix earnings show the streaming content provider continues to gain traction.

Alex Dumortier
Alex Dumortier, CFA
Apr 21, 2014 at 7:00PM

With today's close, U.S. stocks recorded their fifth consecutive winning day -- their first streak of this length since last October (it's been less of a one-way market this year). The benchmark S&P 500 rose 0.4% today, putting it just 1% from its early April all-time high, while the narrower Dow Jones Industrial Average (DJINDICES:^DJI) gained 0.2%. Streaming movie and television provider Netflix (NASDAQ:NFLX) reported its first-quarter results after today's close. As a high-profile momentum favorite, the report is a stern test -- not just for the company itself, but for an entire segment of high-flying stocks (predominantly in the technology sector) that have come under some pressure recently after posting remarkable gains. If today's after-hours action in Netflix shares is any indication (and it usually is), the company passed this test with flying colors -- the stock is up 6.5% at 6:54 p.m. ET.

What did it take for the stock to pop in after-hours pop trading? A beat on earnings per share is a good start, as adjusted EPS came it at $0.46 against Wall Street's consensus estimate of $0.41. On revenues, Netflix was essentially in line with the consensus estimate, at $1.27 billion against $1.266 billion -- although the difference is less than 0.3%, symbolically, it's a beat, and that alone is enough to help boost sentiment.

Netflix is a fine example of growth company that continues to expand at rates that are a multiple of that of the broad economy. That expansion requires investment, which it funds through the issuance of common stock and operating profits. As CEO David Hastings and CFO David Wells wrote in today's earnings letter:

Free cash flow in the quarter was $8 million versus net income of $53 million. As we've highlighted in previous letters, investments in our original series as well as certain non-original licenses, can require higher initial cash payments over the P&L expense. With further international expansion in the second half of this year reducing net income, we expect free cash flow in Q4 to also be reduced.

Their model is working; for example, losses in the international segment narrowed by more than half year on year, and the business is now "on a path to achieve profitability this year." International revenues now represent a quarter of Netflix's total streaming revenues. In the domestic streaming business, the contribution profit margin has increased to 25.2% from 20.6% in the year-ago period, and the company expects to rise to 26.7% in the current quarter.

The difficulty for investors is in trying to value a company at this stage of its development. Given the reinvestment needs, profitability associated with a mature business is tricky to estimate, as is the duration of the hyper-growth period. Are Netflix shares worth 88 times the next 12 months' earnings-per-share estimate? That looks too rich for my blood, but it's tough to capture the complexity of and interaction between the factors I mentioned earlier in a forward price-to-earnings multiple. Consider that, since March 31, 2013, that multiple has fallen from 143 to 88 -- despite the fact that the stock price has risen 84% during the same period. How? The next 12 months' EPS estimate has tripled.

For fundamental investors, this recent quarter shows the strength of the momentum underlying the business, while traders are looking for a different type of momentum -- that of the stock price. This report ought to satisfy both of them.