Earnings season kicked off with an interesting report from Netflix, Inc. (NASDAQ:NFLX). It really was the definition of a mixed bag, and NFLX stock acted accordingly, rising at the open before succumbing to weakness shortly thereafter.
Netflix’s revenues merely met expectations, second-quarter sales estimates were shy, and net adds in the quarter were below the consensus mark. However, earnings beat estimates, and the Q2 net add guide was above expectations.
All in all, NFLX stock didn’t have the post-market firepower investors are accustomed to seeing after earnings. Netflix bounced around after-hours, started Tuesday higher but dipped with the rest of the market after the fact.
Why?
Well, Wall Street is trying to balance subscriber growth with profitability when it comes to Netflix. Q1 was poor sub growth with good profitability. Q2 will be good sub growth with poor profitability.
These quarter-to-quarter fluctuations in sub growth and profitability, though, are just noise in the bigger picture for Netflix. That bigger picture is a company that is both growing quickly and becoming more profitable. It is a win-win, long-term trend.
That is why I am largely ignoring the specific quarterly numbers which Netflix investors have long been obsessed with. Instead, I am choosing to focus on one number from the Q1 report.
The Most Important Number From The Netflix Report
That number is 7%.
7% is how high Netflix management thinks operating margins will reach this year. That is up dramatically from the 4% run-rate we have seen over the past two years. It represents the undeniable fact that sub growth and revenue scale are driving operating expense leverage.
It also represents the undeniable fact that quarter-to-quarter fluctuations in profitability are just noise. In Q4, Netflix guided for 7% operating margins in full-year 2017. In Q1, management affirmed that 7% full-year operating margin target. That confirmation came despite significant margin oscillation between Q1 and Q2.
Simply put, Netflix just didn’t invest as much in original content in Q1 as they had in prior quarters. As a result, sub growth lagged, but profitability soared. Netflix expects to ramp back up content investment in Q2. Consequently, subscriber growth is expected to pick up and profitability is expected to compress.
Big picture, investors should ignore the quarterly noise. Instead, they should focus on the fact that operating margins are expected to nearly double this year. That is impressive, especially for a company getting knocked for spending too much.
Bottom Line on NFLX Stock
Is NFLX stock richly valued? Yes, if you ignore the fact that this is a company with $10-plus annual earnings-per-share potential. Revenues continue to grow north of 30% per year. Price hikes are having a materially positive affect on contribution margins. Big original content investment is resulting in big net add numbers. Operating margins are starting to boom.
While the financials may look ugly now (just look at the free cash flow), management is creating something very valuable. Netflix is the king of Internet TV, which is a secular growth market that is showing no signs of slowing. They have acquired some of the best streaming content from Walt Disney Co (NYSE:DIS). They continue to pump out a diverse array of quality original content. Netflix is also capitalizing on global Internet growth and appealing to international audiences.
At the end of the day, management is doing everything right to turn Netflix into a high-margin, cash-flow machine over the next several years.
I think the market is starting to look at Netflix that way, too. NFLX stock usually tanks when it misses on the subs number, but the stock actually was primed for gains Tuesday before being caught in the broad-market undertow.
The Netflix investor crowd is turning into a resilient bunch, and this stock should ultimately head significantly higher in a long-term window.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities, but may initiate a position in NFLX over the next 72 hours.
