A Thorough Breakdown of Netflix's (NFLX) Outstanding Fourth Quarter

In December Netflix (Nasdaq: NFLX) CEO Reed Hastings sent out a warning letter to short sellers not to bet against the company as growth was just getting started. Yesterday's earnings report from the streaming movie rental giant proved that Hastings words were not made in jest, as the company blew-away subscriber and earnings expectations.

Today Wall Street, which has bet heavily against stock, scrambled to reverse their foolish bets. Heading into the noon hour, shares of Netflix are up over 13 percent to $207.70.

Illustrating just how wrong the Street has been on the stock is the unprecedented five upgrades seen on the stock just today. That's not even to mention the estimates and price target hikes at nearly every investment bank that covers the stock.

While Wall Street has been mostly wrong on the stock, they do a good breakdown of the results.

Q4 Results:
Canaccord Adams (Buy): Revenue was $596M (+34% YOY vs. +31% in Q3), roughly in line with consensus at $598M; GAAP EPS of $0.87 (+56% YOY vs. +35% in Q3) were well ahead of consensus of $0.71. Gross margin (incl. fulfillment) of 43.5% in the Q was down 365 bps from 3Q and down 441 bps from Q4/09 on expanding content library and a full quarter of operations in Canada. Netflix generated $51M in FCF in the Q, up from $8M in Q3/10 and $30M in Q4/09.

Subscriber Metrics:
Goldman Sachs (Neutral): "Netflix reported 4Q subscriber net adds of 3.08 mn, above our 2.9 mn estimate and consensus expectations of about 2.6 mn. For the full year, net subscriber adds increased 169% yoy at 7.7 mn, more than double the company’s guidance in early 2010. During the quarter, free subs accounted for around 9% of total subs, up from around 3% in the year ago period (and around 6% in 3Q2010), which the company attributed to the extension of free trials from 2 weeks to 1 month as well as strong growth near then end of 4Q due to holidays. Monthly churn of 3.8% was inline with our estimate and down slightly from 3.9% in 4Q2009, helped by better availability of high-quality digital content."

Gross Margins
Jeffereis (Hold): GM of 34.4% came in below our 36.3% estimate and consensus of 35.8%. Netflix spent $174.4M in 4Q to acquire streaming content ($207.3M inc. DVDs), well ahead of our est., reflecting the rapidly growing levels of investments needed to sustain digital viewing.

Operating Margins
Jeffereis (Hold): Oper margin increased 120bps y/y to 13.2%, helped by lower mktg exp in 4Q. SAC plummeted to $11.13 vs $19.62 in 3Q, as mktg exp decreased 10% y/y. Mgmt expects marketing costs to pick-up again in 1Q.

Guidance
Wedbush (Undperform): For Q1, the company expects revenue of $694 – 717 million, ending subs of 22.65 – 23.7 million, and EPS of $0.90 – 1.13. For the year, the company committed to an operating profit of 14%, continued subscriber growth, profitability in Canada, and a $50 million operating loss from international operations/

Annual Guidance Disclosure:
Janney Capital (Neutral): NFLX will no longer provide annual guidance for EPS and sub growth, which we believe will increase risk and the variance in street estimates. Furthermore, NFLX will stop providing key metrics for gross sub adds, SAC, and churn that will prevent the street from analyzing underlying trends. Given the propensity for major changes in these metrics with intensifying competition and the move to usage based billing of data, we believe there is now a greater potential for investors to be blindsided by changes in the landscape.

International:
Janney Capital (Neutral): Management is forecasting 0.75 to 0.90 million Canadian subs by the end of 1Q11 and profitability by 3Q11. Given the UBB pricing that exists in Canada, it will be important to see how these sub levels hold up as Canadians realize they face large data bills.

Free Cash Flow:
Goldman Sachs (Neutral): Netflix generated $51 mn in free cash flow in 4Q, up 70% yoy, and above our ($30) mn estimate on higher cash from operations ($97 mn, down 9% yoy) and generally inline capex ($14 mn, down 36% yoy) and acquisitions of DVD content

Starz Renewal
Janney Capital (Neutral): NFLX noted that its Starz contract does not expire until the middle of 1Q12, which is 6 months longer than expected. This allows NFLX to delay the massive inflationary costs of renewing this deal and may give the company more time to develop strategic alternatives. Maintains Neutral, ups target from $145 to $175.

Other:
Canaccord Adams (Buy): "More than 1/3 of new subscribers are signing up for the pure streaming plan, and Netflix expects that % to grow over time; the balance of new subscribers primarily takes the company’s $9.99 1-DVD combination plan. Very few existing subscribers are downgrading to the pure streaming plan. Netflix’s $7.99-per-month plan, as well as its $9.99 1-DVD combination plan, is for one stream at a time; later this year the company will offer consumers some account options to watch multiple simultaneous streams."

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