3 Things to Watch When Netflix Reports Q2 Earnings

Streaming video leader Netflix is scheduled to report earnings next week. Netflix is the top-performing stock in the S&P 500 this year, having roughly doubled in the past six months, so investors clearly have high expectations.

Can Netflix manage to keep the good times rolling? Or could investors face another setback that ends the party -- at least temporarily? Here are three things investors should look out for when Netflix releases the earnings report on July 15.

Did Netflix overcome seasonality?The second quarter is always the weakest for Netflix as the arrival of better weather in the Northern Hemisphere encourages people to go outside and watch less TV. In the past, Netflix has warned that its Q2 domestic subscriber growth is likely to decline year after year.

Netflix typically faces slow subscriber growth during Q2. Photo: The Motley Fool

Last year, this scenario played out, as Netflix added 0.57 million domestic streaming subscribers in Q2, down from 0.60 million in the prior-year quarter. In addition to this normal seasonality, Netflix told investors in April that it plans to shift some marketing spending from the U.S. to international markets in Q2. This could also have weighed on domestic subscriber growth last quarter.

Yet surprisingly, Netflix forecast in April that it would add 0.60 million domestic streaming subscribers during Q2. That would be up slightly from the 0.57 million added in Q2 2014.

If Netflix can meet or exceed this guidance, that would be great news for investors. First, it would show that Netflix doesn't need to spend big on marketing in the U.S. to keep growing. Second, it would provide additional evidence that Netflix is on track to hit its long-term domestic subscriber count and profitability targets.

Are domestic content costs taking off again?A second item for investors to keep an eye on is domestic content costs. Netflix has seen its domestic streaming contribution margin skyrocket over the past year, thanks to slowing content cost growth.

For example, in Q1, Netflix's domestic streaming "cost of revenues" -- a rough proxy for content costs -- rose 12.7% year over year and just 1.6% sequentially. By contrast, domestic cost of revenues had risen by 17.4% year over year and 4.2% sequentially in Q1 2014.

However, Netflix's Q2 guidance implied that domestic contribution costs -- a metric that includes both the cost of revenues and marketing expense -- would rise by $23 million sequentially in Q2. Considering that Netflix plans to slash domestic marketing spending, this implies that domestic content cost growth could accelerate to $40 million or more, sequentially.

Will Netflix's content cost growth start to accelerate again? Photo: The Motley Fool

This isn't the end of the world. For now, Netflix can absorb higher content costs by growing its subscriber base and increasing its average revenue per user. But with more big content expenses coming down the pipeline -- most notably a deal for Disney movies -- a quick return to rapid content cost growth will increase the pressure on Netflix to maintain its strong subscriber growth rate.

Is the strong dollar worsening international losses?After nearly reaching breakeven in its international markets in Q2 2014, Netflix has accelerated its international expansion. This has driven international losses higher. Netflix posted a $65 million international contribution loss in Q1 and projected that the international contribution loss could reach $101 million in Q2.

During the April earnings call, Netflix CFO David Wells attributed the higher losses to having a full quarter of expenses for Australia and New Zealand (where Netflix launched in March) as well as content and marketing investments. He added that the losses would likely rise further later this year and into 2016 as Netflix launches more new markets.

However, Netflix may now be facing an additional headwind in its international business: the strong dollar. A number of the currencies from Netflix's foreign markets -- including the euro, the Canadian dollar, and the Brazilian real -- have fallen 15% or more against the dollar in the past year.

To the extent that Netflix pays for content costs in local currency, exchange rate fluctuations shouldn't have a big impact on profitability. But an increasing proportion of Netflix's content budget is going to originals and globally licensed content, both of which tend to be paid for in dollars.

If a significant proportion of Netflix's international content costs are dollar-denominated, then a strong dollar reduces the amount of international revenue available to cover those costs. And Netflix can't try to push through a price increase every time the dollar strengthens, or it will risk alienating customers in markets that it doesn't currently dominate.

Netflix investors will want to keep a close eye on any commentary about the impact of the strong dollar on international losses. Too big a spike in international losses could force Netflix to slow the pace of its global expansion to avoid dropping below breakeven on a global basis.

The article 3 Things to Watch When Netflix Reports Q2 Earnings originally appeared on Fool.com.

Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool recommends Netflix. The Motley Fool owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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