What to Watch as Netflix Heads Into a Key Earnings Report

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NFLX stock - What to Watch as Netflix Heads Into a Key Earnings Report

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When Netflix (NASDAQ:NFLX) reports Q3 earnings next Tuesday afternoon, the unspoken goal will be rather simple: avoid a repeat of Q2. The Netflix stock price fell 5%+ after the second quarter report in July. NFLX stock would go on to drop over 20% before regaining some of the losses.

The path to that goal is pretty simple: drive subscriber growth. It was a subscriber miss that led to the post-Q2 plunge in the Netflix stock price. It will take subscriber gains to get NFLX stock back to $400 and beyond.

Profitability would be nice, and it will get some attention. But it’s truthfully not that important at the moment. (Indeed, earnings per share actually came in 6 cents ahead of estimates in Q2.) That’s not because the market ‘doesn’t care’ about profits; it’s because from a long-term standpoint, today’s subscribers are going to drive tomorrow’s profits. That’s just one of three reasons why Q3 numbers look particularly important to Netflix as a company, and to the Netflix stock price.

Content and the Netflix Stock Price

While Amazon (NASDAQ:AMZN) has expanded from originally selling just books to being a globally diversified provider, Netflix has made a substantial pivot of its own. What was once simply a distributor of DVDs now is one of the world’s largest content creators — not just distributors.

As I pointed out back in March, Netflix’s 2018 orignal content slate includes some 80 movies. In 2017, the six largest studios in the U.S. combined released just 94 films.

To sustain that kind of volume, Netflix has to essentially become the biggest and best creator of content in the world right now. And a Q3 subscriber miss might lead investors to wonder if the huge amount of spend for those films and shows — some $13 billion — is paying off. Indeed, InvestorPlace’s James Brumley just last week asked that very same question.

And with a few missteps along the way already — like the $90 million Will Smith vehicle Bright and ‘fat-shaming’ criticism of its teen drama Insatiable — there does appear a risk to the Q3 numbers.

On the other hand, Netflix’s ability to target viewers directly — both in delivering already-created content and in developing new films and series based on existing desires — gives it an enormous edge. Q3 numbers will give another data point as to whether that edge translates into more subscribers.

Competition Is Coming

Meanwhile, competitors are coming for Netflix — most notably Walt Disney (NYSE:DIS). Disney’s acquisition of assets from Twenty-First Century Fox (NASDAQ:FOX,FOXA), along with properties like Star Wars, will back its own streaming service. It will also make Disney a 60% owner of streaming service Hulu, with Comcast (NASDAQ:CMCSA) and AT&T (NYSE:T) owning minority stakes.

Streaming isn’t going to be a zero-sum game. Consumers may very well subscribe to both Netflix and the Disney offering (and Hulu). But if Netflix’s customer count is stalling out ahead of Disney’s launch next year, the narrative around NFLX stock can change in a hurry. Weak growth and a rising, respected rival will be a poor combination for the Netflix stock price.

Incremental Margins Will Drive NFLX Stock

It might sound like the focus on subscribers is a case of a bubbly market ignoring what really matters: profits. Perhaps there are echoes of the dot-com bubble-era discussion of “eyeballs”.

But the growth in subscribers is what will drive Netflix earnings, and the Netflix stock price, going forward. Netflix’s incremental margins are simply huge. The cost to add a subscriber for a year is close to negligible. And so margins — and profits — can expand enormously as subscriber count grows.

Indeed, operating margin expanded from under 5% to nearly 12% in the second quarter. It’s that type of expansion — and the potential for more going forward — that allows NFLX stock to trade at more than 80x earnings.

There’s a fundamental reason why subscriber growth is such a point of investor attention. It’s not because the market isn’t paying attention to profits; it’s because it is.

The leverage of subscriber growth in the model is amplified from a free cash flow standpoint by the huge investment in content spend. Netflix’s $13 billion in content spend this year can be monetized — for free — for years to come. Assuming, of course, Netflix has the requisite subscriber base in those coming years.

Particularly after the Q2 subscriber miss, that makes Q3 a very important report. History suggests Netflix will bounce back; it usually does. But if it doesn’t, it will be a long way down for NFLX stock.

As of this writing, Vince Martin has no positions in any securities mentioned.

After spending time at a retail brokerage, Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets.


Article printed from InvestorPlace Media, https://investorplace.com/2018/10/netflix-heads-key-earnings-report/.

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