Since its disappointing earnings report last month, Netflix (NASDAQ:NFLX) stock has declined 17%. And the pressure hasn’t let up of late: Netflix stock has reached its lowest levels since last December.
It’s not difficult to see why. Netflix stock is a story based on subscriber growth, as I wrote after NFLX reported disappointing user metrics in last year’s second quarter. And its numbers on that front were terrible in its recent Q2 report.
With Netflix stock now back below $300, some investors might see a “buy the dip” opportunity at this point. The growth of streaming is going to continue, and NFLX remains the leader of that market. Indeed, I’ve recommended buying NFLX stock on weakness in the past; in November, I called the stock the best contrarian bet in tech.
But this is a different situation. The selloff late last year was driven by external factors – most notably, a plunging stock market that dragged down many, if not most, highly-valued growth stocks with it. NFLX itself was performing reasonably well. And in fact, there was (and is) an argument that Netflix stock would benefit from a recession, which might accelerate cord-cutting as consumers look to save money.
The recent selloff of Netflix stock is based on the company’s performance, however. And as weak as that performance looked in Q2, when combined with what’s going on elsewhere in the U.S. content sector, it’s something close to disastrous. As a result, it can get worse before it gets better for Netflix, and for Netflix stock.
Q2 Subscriber Numbers Hammer NFLX Stock
Netflix’s headline numbers actually looked solid. GAAP EPS of 60 cents beat consensus expectations by 4 cents. Revenue of $4.92 billion rose 33% and was in-line with analysts’ average estimates.
But the subscriber figures were the big issue for Netflix stock, and led to a 10.3% decline by NFLX stock. Net paid subscriber additions of 2.7 million badly missed the company’s guidance of 5 million. As a helpful chart in the Q2 shareholder letter showed, that was the biggest miss relative to guidance since at least the beginning of 2016.
And it was the U.S. market that caused the miss. Netflix’s U.S. paid subscriber count actually declined in the quarter for the first time since 2011.
That alone likely drove investors to flee Netflix stock. But NFLX has continued to fall, dropping another 8% from its immediate post-earnings levels. That continued decline may come from a growing realization that the quarter was even worse than investors initially realized.
The Content Question for NFLX Stock
One of the reasons that Netflix stock has been so divisive is that the company continues to burn cash. Its content spending is expected to come in above $15 billion this year.
That spending makes some sense. Instead of licensing content – and paying for it annually – NFLX essentially is buying its content upfront. Free cash flow now might be negative, but if that content drives subscriptions down the line, its free cash flow several years from now will be higher, making the near-term investments worthwhile.
But that strategy only works if subscribers will stay with NFLX for a long time, allowing that content to be monetized in future years. That alone makes the Q2 subscriber decline concerning. So does a widely-cited passage from the company’s shareholder letter: “We think Q2’s content slate drove less growth in paid net adds than we anticipated.”
If that’s the case, NFLX has a problem. It means the company can only keep adding subscribers if it continues to spend a great deal on content That sounds an awful lot like the old joke about selling at a loss, and making it up on volume. If Netflix’s content budgets can’t come down, free cash flow will stay negative or at best modestly positive. And that does not support the market capitalization of NFLX stock, which still sits at $130 billion.
Where Are the Cord-Cutters Going?
There’s another major concern about Netflix’s Q2 results. Specifically, Netflix’s weak performance came at the same time that cord-cutting appears to have accelerated.
Indeed, legacy cable companies had a horrible quarter. AT&T (NYSE:T) lost almost 1 million video subscribers. Comcast (NASDAQ:CMCSA) and Charter Communications (NASDAQ:CHTR) lost a combined total of nearly 400,000 viewers.
Industry analyst MoffettNathanson called the quarter “freaking ugly” for cable companies and projected an unprecedented 5.5% cord-cutting rate in the quarter.
So the question relative to Netflix numbers is: where are these subscribers going? One answer might be Hulu, now majority-owned by Disney (NYSE:DIS). At the Disney Investor Day in April, the company said Hulu had more than 25 million paid subscribers. Earlier this month, the company said the figure was “approximately 28 million.”
Whatever the case, Netflix should have been set up to have a blowout Q2 on the subscriber front in the U.S. Instead, it posted a stunning decline. In that context, its performance looks even weaker, and more concerning, than a simple guidance miss.
The Competitive Concern for Netflix Stock
I wrote ahead of NFLX’s Q2 results that the earnings report was critical for Netflix stock. And a key reason is that new competition is on the way from Disney, AT&T, and Comcast.
Netflix, in its shareholder letter, wrote that it didn’t think competition was a key factor in the disappointing subscriber numbers. That may well be true. But competition will be a factor in 2020, when those streaming services – with a great deal of content, backed by high marketing budgets – come online.
And so investors can rightly wonder: if Netflix’s U.S. subscriber growth is stalling out already, what happens when its competition increases next year?
Netflix stock bulls might respond that the U.S. isn’t Netflix’s only market. That’s true: the company now has more subscribers overseas than in the U.S. More of its revenue comes from overseas as well.
But about two-thirds of its profits still come from the U.S.. America is still the company’s key market. And with NFLX stock trading at 53 times analysts’ average 2020 EPS estimate, a stumble in the U.S. is likely to prove damaging for Netflix stock.
On the other hand, the company’s Q3 guidance was strong, and it’s possible NFLX can bounce back. But its Q2 performance raises real questions and suggests more downside for Netflix stock could be ahead. It’s the type of quarter that raises concerns about the company’s overall strategy and market positioning, as well as the valuation of NFLX stock.
And that’s why it’s been the type of quarter that leads not only to a big post-earnings decline, but more selling in the following weeks. Investors who buy the dip of Netflix stock do so at their peril.
As of this writing, Vince Martin has no positions in any securities mentioned.