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Netflix - Shares tumble on slowing subscriber growth

Nicholas Hyett | 18 July 2019 | A A A
Netflix - Shares tumble on slowing subscriber growth

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Netflix Inc Common Stock US$0.001

Sell: 386.17 | Buy: 386.38 | Change -1.59 (-0.41%)
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Netflix's revenues continue to climb rapidly, up 26% year-on-year to $4.9bn, and operating profits of $706m have come in well above market expectations.

However, subscriber growth has been subdued this quarter. Net additions of 2.7m new subscribers is well below both market expectations and the company's own guidance of 5m.

The shares were down 12% in aftermarket trading.

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Our view

Netflix continues to deliver show stopping revenue and profit growth. But unfortunately that's not always enough.

Expectations are high. Adding millions of new customers a quarter and delivering price hikes across the groups major markets won't necessarily keep investors happy. The group's business model demands that it builds scale. Netflix needs to spread its cost over a larger customer base. As a result missing subscriber targets hurt Netflix shares more than just about any other metric.

While Netflix has been quick to say that recent subscriber growth slowdowns are not due to increase competition, competition in the industry is certainly heating up. Amazon, Apple and Disney are all expanding and they're not rivals to be taken lightly.

To keep adding new customers and entertain its existing audience, Netflix is spending heavily on marketing, while the content budget has burst past $10bn a year. This includes making Netflix originals - think Stranger Things, Bird Box and Ozark - and licenced content from other production houses.

That spending means Netflix is burning through cash. So far it's been able to plug the gap with affordably priced debt because the market is optimistic it'll be taking in more than it spends in the not-too-distant future. If that happens the scalability of the business means cash flow could improve rapidly, explaining the shares' premium valuation of 78 times expected earnings prior to the most recent set of results.

We're prepared to give Netflix the benefit of the doubt for now. The group's third quarter slate is far stronger than Q2 and pushing marketing later in the year will have had an effect. We also think the group has more room to increase prices. Netflix viewing time is still dwarfed by conventional TV, so there's plenty of scope for users to get better value for money as streaming increases its share.

However, the pace of expansion from quarter to quarter has proven difficult to forecast. That volatility, plus the heightened risk/reward that comes with a rapidly evolving landscape, means the share price has moved sharply in both directions over the last year.

With competitors coming to market, the next two quarters will be crucial.

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Second Quarter Results

Operating profit improvements reflect the increase in average revenue per user in both the US and international markets, from increased prices and a shift of some marketing spend into the second half.

Free cash flow deteriorated both quarter-on-quarter and year-on-year, with Netflix burning through $594m of cash in the quarter. That's primarily due to the $3.3bn spent on content during the quarter.

Netflix now has 151.6m paying subscribers. Management do not believe that the slowdown in subscribers was due to increased competition, with slower growth across all regions and a more pronounced slow in countries that saw price increases.

Netflix has a strong slate of releases in the third quarter, including Stranger Things series 3, and new series of The Crown and Orange is the New Black. That underpins upbeat guidance for next year quarter. Management expect third quarter revenues to rise 31.3% year-on-year, with operating profits of $833m and 7m new subscribers.

The group raised 10.5 year debt worth EUR1.2bn and $900m during the period, at 3.875% and 5.375% respectively, to fund continued content development. Netflix expects to continue raising debt to fund content in the years to come.

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