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Netflix - lockdowns boost subscriptions, but margins suffer

Sophie Lund-Yates, Equity Analyst | 22 April 2020 | A A A
Netflix - lockdowns boost subscriptions, but margins suffer

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Netflix Inc Common Stock US$0.001

Sell: 515.89 | Buy: 516.27 | Change -0.48 (-0.09%)
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Increased demand for streaming during lockdowns meant Netflix added 15.8m net new paid subscriptions in the first quarter, far exceeding analyst expectations. In the first two months of the quarter membership growth had been in line with previous years.

Overall revenue of $5.8bn was in line with Netflix's previous expectations, as the appreciation of the US dollar offset the increase in subscriptions.

Operating income was $958.3m, compared to $459.1m last year.

The shares were broadly flat in after-hours trading.

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Our view

A world in lockdown means we're consuming more TV, and has helped Netflix win an impressive number of new subscribers.

Intuitively that's good news, especially since the business model demands that Netflix builds scale and spreads costs over a larger customer base. Subscriber numbers are still very much the metric to watch.

But having millions of extra eyes on its screens isn't a straight forward victory for Netflix. With so many of us consigned to the couch, we're probably burning through our favourite shows at a much faster rate than usual. At the same time, a halt to production means the content reserves risk running low.

That's not an imminent problem and its peers should be in the same boat, but it means there'll be pressure to pull a lot out of the bag pretty quickly once sets get back up and running. Quickly creating the next generation of "must see" content is important because staying ahead of the pack has become a lot more difficult. There are big rivals like Amazon, and Disney has seen a fiercely strong response to its new streaming service. Encouragingly there are lower rates of churn in the US and Canadian markets, but it would be a mistake to think Netflix can rest on its laurels.

That brings us nicely to the issue of free cash flow. In order to satisfy customers and entice new ones Netflix spends over $13bn a year on content (prior to coronavirus). This includes making Netflix originals - think Love is Blind and Tiger King - and licenced content from other production houses.

As a result free cash flow is strongly negative. Savings from the production shut downs means this year will be an improvement, but the path to positive free cash flow will be lumpy at best from here. Although, as a long term bug bear, it was a relief to hear the virus hadn't completely obscured the destination.

Overall we worry lockdowns have intensified the competitive landscape, and simply brought forward future subscriptions. In that scenario if Netflix is forced to ramp up content spending to keep hold of existing customers, rather than chasing new ones, it wouldn't be the best news - especially for what's supposed to be a stellar growth stock.

Investors should keep in mind that a price to earnings ratio of 63.1 means the shares could fall sharply if growth disappoints.

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First quarter trading details

Average revenue per user in the US and Canada rose 14%, and there was a 4% increase in Europe, Middle East and Asia. Latin America rose 12%, while Asia Pacific reported a decline of 3%.

Ignoring the impact of exchange rates, average streaming revenue per user increased 8%, to $10.87.

Operating margins of 16.6% were lower than expected, and reflect the impact of pausing productions due to coronavirus, as well as contributions to hardship funds. Despite the extra costs Netflix is still targeting a 16% operating margin for the full year.

Netflix has taken on an extra 2,000 customer support agents - all are working from home.

Net cash used in operating activities was $260m vs. -$380 million in the prior year. The pausing of productions means some cash spending will be deferred to later dates, and the group now expects free cash flow (FCF) of -$1bn for the full year. It had been expecting -$2.5bn.

The group said: "there has been no material change to our overall time table to reach consistent annual positive FCF and we believe that 2019 will still represent the peak in our annual FCF deficit."

The group finished the quarter with cash of $5.2bn, and has access to $750m of undrawn credit. Netflix thinks it has over 12 months of liquidity and intends to continue using debt to finance its investment needs.

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