- Netflix reported impressive Q3 earnings that beat both top and bottom line expectations.
- More importantly though, the company's subscriber growth easily exceeded expectations.
- Can Netflix maintain this positive trend or was this another flash in the pan?.
Netflix Inc. (NASDAQ:NFLX) stock is one of the most famous battleground stocks in the tech sector. Netflix reported Q3 earnings yesterday and, unlike the previous quarter, the bulls carried the day. The video streaming company blasted past Q3 earnings and subscriber growth estimates as accurately predicted by fellow Amigo Bulls contributor, sending the stock soaring 20.6% in after-hours trading.
Netflix 5-day share returns
Source: CNN Money
Netflix reported EPS of $0.12, which was good for a healthy 71.4% Y/Y growth while Q3 revenue of $2.3B was 32.2% higher compared to last year's corresponding quarter. As usual, investors were more keen on subscriber numbers. And Netflix did not disappoint on this front either. The company added 370K domestic subs during the quarter, way higher than Wall Street consensus of 304K and its own guidance of 300K subs. That's more than double the 160K subscribers the company added last quarter.
Net international subscribers clocked in at 3.2M vs. 2.0M consensus. Netflix finished the third quarter with 86.74M total members. Meanwhile, total streaming contribution margin climbed 120 bps to 18.8% with U.S. contribution margin clocking in at 36.9%, a healthy 450 bps Y/Y increase. Netflix said that it has so far managed to un-grandfather 75% of its members. What this in effect means is that the vast majority of Netflix subscribers are now paying the higher $9.99/month rate, up from the previous lower rates of $7.99 and $8.99 per month. This is obviously good for the top line and might be part of the reason the company posted impressive growth in the latest quarter.
Netflix Subscriber growth defies expectations
One of the most important takeaways from Netflix's latest earnings call is that the company still managed to post impressive subscriber growth both domestically and in the international market despite the un-grandfathering of older customers. While some bullish Wall Street analysts had voiced their suspicion that the company was being too conservative with its subscriber guidance, nobody really expected the company to add more than 3M international subs. This suggests that the company's heavy investments in original programming could be drawing in new customers. The company recently released popular originals such as The Get Down, Stranger Things, Luke Cage, and Narcos season two.
Netflix has managed to add 12M new subscribers during the first nine months of the year, roughly the same it did over a similar timespan a year ago. The company expects to finish the year with a moderate year-over-year decrease in net subs, which clearly indicates that fears about massive churn due to the $2 price hike were unfounded. Further, the company said that it does not plan to effect any more price hikes this year.
Strong Q4 2016 guidance
Netflix spiced up things further when it said it expects to add 5.2M subscribers globally during the fourth quarter which includes 3.75M internationally. The company also guided for Q4 revenue of $2.344B, good enough for a robust 40.2% Y/Y growth and EPS of $0.13, 30% higher than last year's comparable quarter.
A few red flags
Netflix earnings, however, did contain some glaring weaknesses, notably a rapidly deteriorating free cash flow. Free cash flow saw a drastic decline from negative $252 million last quarter to negative $506 million this quarter. And that's after adjusting for a $530M boost in the form of a positive contribution in streaming content liabilities.
The biggest reason why Netflix's FCF is trending south can be summed up in one phrase: rising content costs. Netflix has been spending heavily on original content and intends to continue doing so in the coming quarters. Netflix plans to increase original programming from 600 hours currently to 1,000 hours in 2017. The big advantage of pivoting to original content is that whereas producing a series such as Stranger Things internally requires more cash up-front, it's cheaper over the long-run since internal projects are not burdened by studio markups and global licensing rights.
Over the short and medium term, however, Netflix has little choice than to continue licensing content from its cable partners to keep all its subscriber bases covered. This heavy spending on content has been taking a big hit on the company's FCF, and is likely to continue doing so--Netflix expects to spend $6B on content purchases in 2017.
With so much pressure on cash flow, Netflix might have little choice than to issue debt or start making frequent trips to the capital markets in order to fund long-term growth. Earlier this year, the company said that it might have to issue bonds later this year or in 2017 to fund its operations. Luckily for investors, the company's debt load stands at less than 10% of enterprise value, which is quite low. Moreover, with interest rates likely to remain low for the foreseeable future, this is more of a long-term risk rather than short or medium-term risk.
Netflix has been investing heavily in original content, and this strategy appears to be working well judging by the company's resurging subscriber growth. While these heavy investments are likely to continue being a drag on profitability and cash flow, Netflix's expanding subscriber base is likely to help both metrics improve in the future. Netflix stock appears to be returning to investors' good books, and this bodes well for the long-term outlook for NFLX stock.
Also see: Amigobulls latest top technology stock picks.