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Netflix - Bumper subscriber growth returns

Nicholas Hyett | 17 October 2019 | A A A
Netflix - Bumper subscriber growth returns

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Netflix Inc Common Stock US$0.001

Sell: 302.86 | Buy: 302.94 | Change -1.46 (-0.48%)
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Netflix added 6.8m net new subscribers in the third quarter, just shy of the group's 7m target. Operating profit came in well ahead of market expectations, with negative free cash flow improving year-on-year to $551m.

The shares rose 9.9% in after-market trading.

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Our view

Netflix continues to deliver show stopping revenue and profit growth. That's driven by millions of extra subscribers every quarter, helped along by recent price hikes in some of its core markets.

Expectations are high though, and recent performance hasn't always been enough to keep investors happy. The business model demands that Netflix builds scale and spreads its costs over a larger customer base. As a result missing subscriber targets hurts Netflix shares more than just about any other metric - and the group did just that earlier this year.

While Netflix was been quick to say the slowdown wasn't due to increased 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.

Adding new customers and keeping existing audiences entertained, means Netflix is having to spend 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.

All 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 57 times expected earnings prior to the most recent set of results.

We're prepared to give Netflix the benefit of the doubt for now. Third quarter subscriber growth has recovered strongly from the second quarter dip and more marketing spend later in the year will have 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.

Nonetheless the next quarter will be crucial. Churn in US customers is already rising, and with competitors stepping up activity across the rest of the year, the risk of customers slipping out the backdoor will only increase. If that happens the group's impressive content budget might have to be redirected towards keeping hold of what it's got rather than breaking new ground. That would not be good for what's supposed to be stellar growth stock.

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Third Quarter Results

Subscriber growth was driven by 6.3m new international subscribers, with US subscriber growth slowing after the group increased prices. However, increased prices helped drive Average Revenue Per User (ARPU) higher, and total group revenue rose 31.2% year-on-year to $5.2bn.

Operating margins of 18.7% were better than expected, as content and marketing spend was pushed into the fourth quarter. Operating profit of $980m was 103.7% ahead of last year. Higher profit's underpinned the improvement in free cash flow. That was despite a 12.7% increase in spending on new content - which stood at $3.6bn during the quarter.

Netflix remains focused on Original content, both in TV and film from Stranger Things Series 3 to Martin Scorsese's The Irishman which is due to launch in Q4. The group is also increasing its spending on non-English language content in regions such as Latin America, Japan and India.

The fourth quarter is expected to deliver slightly slower growth, with revenues up 30% year-on-year and 7.6m new subscribers (vs 8.8 last year).

Netflix finished the period with net debt of $8bn, compared to $6.6bn at the start of the year.

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