Netflix, Inc. Earnings Silence the Doubters (NFLX)

This, however, does not make NFLX stock untouchable

With the dust mostly settled following the suggestion that Walt Disney Co (NYSE:DIS) might be a suitor, Netflix, Inc. (NASDAQ:NFLX) stirred up another whirlwind after Monday’s close by announcing its fiscal Q3 results. And, it was good, sending NFLX stock soaring to the tune of 20% in after-hours trading.

Netflix, Inc. (NFLX) Stock Soars on Earnings Beat, Strong Growth Outlook

In its fiscal third quarter of the year, on-demand video market leader Netflix earned 12 cents per share on $2.2 billion worth of revenue. The company reported earnings of seven cents per share and sales of $1.74 billion in Q3 of 2015. Analysts were expecting a profit of six cents per share of NFLX stock on revenue of $2.28 billion for the quarter.

Netflix added 3.6 million net subscribers during the quarter in question … 400,000 in the United States and 3.2 million overseas members. The company had guided for the net addition of 300,000 new U.S. members for the quarter. FactSet reported an analyst consensus of 310,000 new U.S. subscribers. Internationally, the company had suggested the addition of 2 million new users.

A price increase imposed on long-term subscribers as well as the Olympics in August was expected to stifle subscriber growth, but the company overcame that headwind.

NFLX Stock: Earnings Details

The subscriber growth pace is a big and much-needed victory. was In the second quarter of the year, NFLX was targeting 2.5 million total new users, but only added 1.68 million. The third quarter’s numbers validate the marketability of the company’s product even in the face new competition. CEO Reed Hastings commented on that matter in his letter to shareholders:

“We face immense competition for consumer screen time. Despite video gaming getting better, video messaging and sharing improving, MVPD UI enhancements, YouTube growth, more SVOD services, and other screen time competitors, Netflix continues to win both time and affection. We presume that Amazon Prime Video will become as global as YouTube and Netflix this fall with the launch of the Jeremy Clarkson show. Our challenge is to continue to improve our service and content so that we better meet consumer desires.”

The balance sheet continues to paint a concerning picture, however, as does the cash flow statement. Current content liabilities grew from $2.6 billion a year ago to $3.5 billion as of last quarter. Total liabilities ramped up from $7.7 billion then to $9.8 billion now. Total content obligations (some of which don’t appear in the balance sheet) now stand at $14.4 billion.

NFLX ended the quarter with $969 million in bank — half of its cash position from a year ago — and the operating free cash flow was negative $506 million … twice the negative free cash flow tally from the same quarter a year earlier.

The crux of the costs and liabilities stem from spending that some would say borders on outrageous. Netflix is intent on holding its lead in the maturing OTT television market, but the competition is getting better, and competing is getting more expensive.

Macquarie analyst Tom Nollen explained when he downgraded NFLX stock last month:

“Many countries Netflix is expanding into have been growing pay TV markets with incumbent operators that have invested in VOD/SVOD offerings, often as add-ons to existing subscriptions. In addition, numerous SVOD services have gotten off the ground, often at cheaper prices and offering more local content … US growth could also be tougher in the near term, with more competition from Amazon, which is doubling its content spending this year, and a plethora of OTT options coming to market, from HBO Now to skinny bundles to virtual MVPDs like Hulu Plus. These will all compete for producers’ ‘content and consumers’ time.”

And it may get worse before it gets better. Wedbush analyst Michael Pachter recently opined, “Netflix expects at least another $1 billion growth in spending in 2017, while meanwhile we think that Amazon Video will up the ante for acquiring new content — driving higher content spend for Netflix combined with slowing subscriber growth.”

Yet, the portion of the content library that’s considered “high quality” — one of the frequently touted details of the Netflix service — isn’t what it used to be. Over the course of the past two years, the number of top-250 movies NFLX made available was nearly cut in half.

That stat may reflect the migration from third-party content to home-grown content; Netflix CFO David Wells recently announced that its ultimate goal is to create half of its own content within a few years. That content isn’t necessarily cheaper to make than it is to acquire, however, but it may be worth it in the long run.

The shareholder letter explained:

“Over the long run, we believe self-producing is less expensive (including cost of capital) than licensing a series or film, as we work directly with the creative community and eliminate additional overhead and fees. In addition, we own the underlying intellectual property, providing us with global rights and more business and creative control. Combined with the success of our portfolio of originals and the positive impact on our member and revenue growth, we believe this is a wise investment that creates long term value. Consequently, we plan on investing more, which will continue to weigh on free cash flow. We expect Q4’16 FCF to be similar to Q3’16 FCF. Over time, we will be able to fund more of our investment in programming through the growth in operating profit and margin already underway.”

A great deal of the company’s future depends on expansion overseas.

One way of re-accelerating its growth in foreign markets following the overseas arm’s January launch is the introduction of content in languages other than English. During the second quarter, the company announced it would begin local language support on a small scale, and that happened in September. The initial response has been a positive one.

One international market that had been targeted, China, isn’t going to pan out as hoped. Rather than establish its own branded presence there, NFLX is going to partner with some of China’s established VOD players. Hastings said this partnership wasn’t likely to create significant revenue.

For the quarter currently underway, the company anticipates 5.2 million new members on a  global basis, with 1.45 million net adds in the U.S.and 3.75 million new members overseas. Netflix is expected to earn 7 cents per share of NFLX stock on revenue of $2.39 billion. Although that top line would be 31% better than the year-ago figure, the bottom line would be 30% lower, as NFLX continues to spend heavily in an effort to secure market share.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

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