Why investors aren’t buying Netflix
Netflix Inc. posted very strong third quarter results on Monday, yet the stock failed to move higher as investors may be worried about future gains. After all, its up more than 60 per cent so far in 2017. But more likely, the market is concerned about the company’s massive content spending plans, and how that its hurting free cash flow.
Analysts praised Netflix’s focus on revenue and earnings through initiatives (like its recently-announced price increases on higher-tier subscribers in more mature markets), not just its growing subscriber base, which climbed 850,000 to 52.8 million in the U.S., and rose 3.5 million to 56.5 million internationally.
Management expects those numbers to climb to 54 million and 61.5 million, respectively, in the fourth quarter, on the back of new releases such as Stranger Things Season 2, The Crown Season Two, and Will Smith’s film Bright.
Netflix’s original programs won 20 Emmys this year (ranking second behind HBO), and had 92 nominations in total — the most of any network. However, the marketing costs behind successful programming such as this are forecast to push U.S. contribution profit (Netflix’s own non-GAAP measure) from streaming operations down to 34 per cent in Q4.
Macquarie analyst Tim Nollen noted that would mean this metric declined for three consecutive quarters, after Netflix achieved its 40 per cent target in Q1.
“Content obligations continue to soar,” Nollen told clients, noting that Netflix has US$17 billion of commitments and plans to spend more than US$11 billion in 2018 – more than a quarter of which goes to original programming.
The analyst believes Netflix could push spending on originals above 50 per cent of total content costs in the next three years, as its film output doubles to more than 80 titles next year.
“This will push free cash flow even further into the red in 2018,” Nollen said. “But subscriber additions demonstrate the content investments are working and do drive operating margins up, so investors continue to accept the trade-off.”
Netflix’s streaming U.S. contribution profit guidance of US$556 million fell short of the Street’s US$626 million forecast, with the company pointing to increased marketing investment.
The company’s Q4 subscriber guidance also came in below analysts’ estimates, but RBC Capital Markets analyst Mark Mahaney doesn’t think this should come as a surprise. That’s because of Netflix’s price increase for standard and premium plans in the U.S.
“It is quite plausible that the company could experience a nearterm bump-up in churn due to the price increase, which would impact net additions,” the analyst warned.
But there are several important differences between the company’s new price increase, and that of 2016.
Doug Anmuth at J.P. Morgan pointed to the that fact Q4 is the seasonally strongest quarter for gross additions, so Netflix should be in a better position to offset any spikes in customer turnover. The analyst also noted that the timing of the price hike is much tighter, as there will be no grandfathering of existing plans, and it should be complete in two or three months, as opposed to five. Lastly, it’s happening during a very strong content period.
“The upcoming price increase is manageable and should be better executed,” Anmuth said.
So while Netflix’s profit is on track, so is its free cash flow burn. If the company’s international subscriber base doesn’t see material growth, competition from Amazon.com Inc. puts a significant dent in growth, or if new programming fails to attract viewers, future results will be at risk.
But for now, it’s differentiated content and superior consumer proposition continues to win over audiences, and the market.