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Speculative investor positioning


Tyler Durden
Netflix Misses On Subs, Guides Lower; Burns $422 Million But Is Optimistic Thanks To Adam Sandler
12 days ago




Last quarter investors forgot the negative cash-flow, forgot the soaring cost of content, forgot the rampant competition, and forgot fact that Netflix slashed its domestic subscriber growth expectations, and just bought-the-f##king-record-high because international subscriber growth soared. This quarter, however, they may be less gullible because that surge in international subscribers not only did not happen, but missed by a whopping 370K subs, missing both the street forecast of 3.9 million and the company's own guidance of 3.7 million. Adding to the pain, domestic subscribers of 1.42 million also missed consensus of 1.59 million and the company's forecast of 1.5 million.

Then, unlike last quarter, NFLX's outlook was far less euphoric, and the company now sees Q2 EPS of 15c, 8c below consensus. Revenue was also fractionally below expectations with the company expecting sasles of 2.755BN in Q2, below the 2.76BN est.

Results summary:

  • 1Q revenue $2.64b vs est. $2.65b
  • 1Q GAAP EPS 40c vs 37c
  • 1Q domestic streaming net adds 1.42 million, vs consensus est. 1.59MM vs company forecast 1.5MM
  • 1Q international streaming net adds 3.53MM consensus est. 3.90m vs company forecast 3.7MM
  • 2Q GAAP EPS forecast 15c vs est. 23c
  • 2Q revenue forecast 2.755BN  vs est. $2.76BN

The only silver lining in the report: Q2 subscriber additions, both domestic and international, are expected to once again come above consensus estimates.

  • 2Q domestic streaming net adds 600K, est. 420.5k
  • 2Q international streaming net adds 2.6 million est. 2.1MM

However, considering this quarter's bad miss on guidance, will investors believe it?

Some additional details from the report:

  • Due to content (primarily House of Cards season 5) moving from Q1 to Q2, we had higher operating margins in Q1 (as forecasted) at 9.7% than our plan for the year (about 7%). We forecast operating margin at 4.4% in Q2, placing us on track to reach our 7% target for the full year.
  • The other effect of the content moves is lower net adds in Q1 compared to prior year (as expected) and heavier net adds in Q2 compared to prior year (about double). We have come to see these quarterly variances as mostly noise in the long-term growth trend and adoption of internet TV. For the first half of this year, for example, we expect to have 8.15 million net adds, compared to 8.42 million net adds in the first half last year
  • International net additions decreased 22% year over year, as we lapped our January 2016 launch of over 130 countries, and the accompanying early surge demand, in Q1 2016.

And then this:

For the last several years we’ve had flat operating margins due to established markets funding international expansion with every spare dollar we had. Because of that, the major indicators of our progress were member and revenue growth and US contribution margins. Starting this year, we can be primarily measured by revenue growth and (global) operating margins as our primary metrics.

Just not cash flow.

And speaking of the one thing that nobody dares talk about, the company's unprecedented cash burn, in Q1 the company burned $422 million, which while less than the record $640 million burned in Q4 (over $1 billion in the last 6 months) was $160 million than its cash burn from a year ago. The company still expects to burn a total of $2 billion for the full year.

How the company explains it:

Free cash flow in Q1’17 was -$423 million vs. -$261 million in the year ago quarter and an improvement from -$639 million in Q4’16. The growth in our original content means we continue to plan to have around $2B in negative FCF this year.

 

We have a large market opportunity ahead of us and we’re optimizing long-term FCF by growing our original content aggressively. Negative near-term FCF is the result of the big increases in our original content, combined with small but growing operating margins. Since we want our operating margins to grow slowly so we can spend enough to quickly grow revenue and original content, we anticipate negative FCF to accompany our rapid growth for many years. Our operating margins are our key indicator of improving global profitability; they are already growing and we plan to keep them growing for many years ahead. Eventually, at a much larger revenue base, original content and revenue growth will be slower, and we anticipate substantial positive FCF, like our media peers.

It remains to be seen if the transition from massive cash burn to cash flow positive is as simple as the company expects it to be.

Some disagree: Geetha Ranganathan, commenting on the company's cashflow said "Cash burn is still an issue - the company has $14.5 billion in streaming-content obligations, and expects to fork out over $6 billion this year, making it the biggest spender for non-sports programming."

One thing is clear: expect much more cash burn:

As our slate of content expands, we’ll spend over $1 billion in 2017 marketing our content to drive member acquisition. As part of this, we are investing more in programmatic advertising with the aim of improving our ability to do individualized marketing at scale and to deliver the right ad to the right person at the right time. Buttressing this activity is the substantial earned media coverage around the Netflix brand, technology and content we generate globally through events and activities aimed at journalists and social media influencers. We also market our content extensively to members through our service and with our partners. For instance, we participated in Comcast’s Watchathon in April, providing X1 subscribers unlimited access to Netflix for a week.

As for the competition...

Our investors often ask us about ecosystem change, such as the advent in the US of virtual MVPDs (like Sling, Playstation Vue, DirecTV Now, YouTube TV and Hulu’s forthcoming service). We believe VMVPDs will likely be more directly competitive to existing MVPD services since they offer a subset of the same channels at $30-$60 per month, and may appeal to a segment of the population that doesn’t subscribe to a pay TV bundle. But we don’t think it will have much of an impact on us as Netflix is largely complementary to pay TV packages. Our focus also is on on-demand, commercial free viewing rather than live, ad-supported programming.

 

Additionally, investors ask us about Amazon’s move into NFL football. That is not a strategy that we think is smart for us since we believe we can earn more viewing and satisfaction from spending that money on movies and TV shows.

Netflix also explained why it dropped its popular 5 star rating model with "thumbs up/thumbs down":

As always, our product team has dozens of tests running in the endless quest for even higher member satisfaction. One test that won conclusively last year and has now been rolled out to all members is our new “thumbs-up thumbs-down” feedback model, replacing the 5-star model we have had from our DVD days. The amount of usage we get with this new approach is over twice as many ratings. With this additional personal input, we’ll be able to improve personalization, making your front screen on Netflix even more relevant.

However, forget the potential growth slowdown, or the massive cash burn, or the competition, or pretty much anything else: .by far the scariest thing in the letter to shareholders was the following:

Just ahead of the release of our third film from Adam Sandler, Sandy Wexler , we announced the renewal of our deal with Sandler to premiere an additional four films exclusively on Netflix around the world. We continue to be excited by our Sandler relationship and our members continue to be thrilled with his films. Since the launch of The Ridiculous 6, Netflix members have spent more than half a billion hours enjoying the films of Adam Sandler.

For those wondering where America's once legendary productivity has gone, the answer is in the bolded sentence above.