Date 7/24/07 Netflix (NFLX): 2Q07 Earnings

Current Price $17.27

Review, Lowering target price
52WK HI $30.00 • Industry: Internet Services
52WK LO $17.17 • NFLX: NASDAQ; $17.27 HOLD 4/19/07: $21.70
EPS (TTM) $0.78 • 12-month price target: $16.00 Target: $21.00
Shares Outstanding 70M
Market Cap. $1.2B
Dividend Yield NA
Price/Earnings (TTM) 22X
Price/Sales (TTM) 1.2X
EV/Revenue (TTM) 0.88X
EV/EBITDA (TTM) 9.5X HOLD initiated 3/21/07: $22.48 HOLD 7/24/07: $17.27
Target: $23.00 Target: $16.00
EBITDA (TTM) $100M

Company Description
Netflix is the largest online movie rental subscription service providing
Brian Bolan
more than 6.7M subscribers access to a library of more than 70,000
movie, television and other filmed entertainment titles on DVD. The
Director of Research company offers a variety of subscription plans, starting at $4.99 a month.
Technology There are no due dates, no late fees and no shipping fees. Subscribers
select titles at the Netflix web site, receive them on DVD by U.S. mail and
Jackson Securities, LLC
300 S. Wacker Dr., Suite 2450 return them to us at their convenience using prepaid mailers. Netflix is
Chicago, IL 60606 also offering certain titles through its new instant-viewing feature.
Ph: (312) 253-0578 Valuation and Recommendation:
Fax: (312) 986-0560
The overwhelming number and size of competitors makes an investment
bbolan@jacksonsecurities.com
in Netflix a hard pill to swallow. Competitive concerns have not abated
and are likely to put continued pressure on Netflix throughout the
remainder of the year. We are lowering estimates and target price and
maintain a HOLD rating.
Jackson Securities, LLC seeks to do business with companies covered in its
research reports. As a result, investors should be aware that the firm may have a
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Netflix (NFLX)

Earnings Summary

Netflix posted a yet another good quarter in terms of revenue and

earnings, but the outlook continues to disappoint. Revenue of
$303.693M came in just below our estimate of $304.440M.
Earnings per share came in well above our estimate of $0.23 per
share at $0.37. When we backed out the effect of the gain from a
legal settlement, earnings would have been $0.27 per share.

Gross margin was slightly lower than expected coming in at

35.2%, just shy of our estimate of 35.8%. The gross margin line
continues to show weakness as margins were 91 basis points lower
than the previous quarter and 186 basis points below year ago
levels.

The real news, however, was that Netflix dialed down its
marketing spend, which resulted in higher earnings. We had
estimated about $64M in marketing spend for the quarter and were
pleasantly surprised to see the company spend only $45M. This
compared very favorable to last quarter which saw spending of
$72M and was just 4% less than in the same period a year ago.

Net subscriber change in the quarter was a decrease of 55,000,

compared to an increase of 303,000 in the same period a year ago
and an increase of 481,000 in the first quarter of 2007. The
decrease in subscribers is due mostly to the Blockbuster Total
Access program. Our estimates called for an increase of about
88,000 subscribers in the quarter.

Online video rental market

Blockbuster’s TOTAL ACCESS program is probably the main

reason for the decrease in total subscribers for the quarter. We
believe that most of the heavy users have already switched
providers and the blood letting is likely over. Management more
or less agrees with us via their guidance for next quarter.
Guidance is calling for ending subscribers of 6.7M to 6.9M. The
mid-point of the range is calling for an increase of 58,000.

Brian Bolan 2
Director of Research – Technology
Netflix (NFLX)

Elsewhere in the world of video rental, we note that Movie Gallery

is facing significant troubles and is no longer a good comparison to
Netflix.

Key business metrics

• Churn: Churn is a monthly measure defined as customer
cancellations in the quarter divided by the sum of beginning
subscribers and gross subscriber additions, then divided by three
months. It is reported quarterly in the earnings release.
Churn for the quarter was 4.6% compared to 4.3% in the
same period a year ago and up from 4.4% from the previous
quarter.

• Subscriber Acquisition Cost (SAC): Subscriber acquisition

cost is defined as total marketing expense divided by total gross
subscriber additions. This metric is also found in the earnings
release and is a good measurement of how effective the ad
spending has been.
SAC came in at $44.02 per gross ad compared to $43.95 in
the year ago period and down from $47.46 in the previous quarter.

• Gross Margin: Gross margin is a key metric for investors

to follow as it tells how effective the underlying model is
performing. The higher the gross margin, the better the model is
working. From time to time, the company has opted to reduce
gross margin in order to help secure more market share in hopes
that over time the customers will become more valuable to them.
Gross Margin for the first quarter was 35.2% compared to
37.1% in the year ago period and 36.1% in the previous quarter.

Ad Spend

Following a surprisingly high marketing spend total for 1Q07,

management decided to dial down the ad dollars to $45M for
2Q07. This 37% decline from the previous quarter was certainly
the extra juice the company needed to beat earnings estimates. We
had estimated that marketing would be around 20% of total

Brian Bolan 3
Director of Research – Technology
Netflix (NFLX)

revenue but were pleased to see that the company came in at 15%
of total revenue. Many will argue that this decrease in ad spending
was directly responsible for the lack of growth in subscribers. We,
on the other hand, believe that the marketing that spend had been
too high of late and it needed adjustment. We also believe the
shrinking number of subscribers had more to do with competition
from Blockbuster than it did with Television and online
advertisements.

Valuation

We still believe that earnings are what investors purchase stocks

for, and with our earnings estimate slipping lower yet again, we
feel it necessary to lower our expectations for our target price. We
had previous thought that a 29x multiple to reflected our
expectation of growth in subscribers and earnings. The decrease in
subscribers and limited prospect for growth in subscribers has
helped us move our multiple lower to 25x this year’s estimate of
$0.64. This equates to a price target of $16 per share.

We expect to deliver earnings estimates for 2008 sometime before

the end of the third quarter.

Source: Jackson Securities and company reports Brian Bolan 4

Director of Research – Technology
Netflix (NFLX)

Source: Jackson Securities and company reports

Brian Bolan 5
Director of Research – Technology
Netflix (NFLX)

Source: Jackson Securities and company reports

Brian Bolan 6
Director of Research – Technology
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Explanation of Ratings:
Buy - Expected 12-month absolute performance of +10% or higher than the market price at which time the rating was
issued.
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Distribution of Ratings:
Jackson Securities, LLC has a distribution of ratings among its coverage universe as follows:

Buys – 52.8% (19 of 36 active recommendations)

Holds – 38.9% (14 of 36 active recommendations)
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Jackson Securities has provided investment banking services within the previous 12 months with the following
percentage of the companies they have rated:

Buys – 0% (0 of 36 active recommendations)

Holds – 0% (0 of 36 active recommendations)
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Risks: General economic conditions, economic slowdown/recession, adverse industry news.

Brian Bolan
Director of Equity Research – Technology
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Brian Bolan
Director of Equity Research – Technology