It is the 16th of February 2020

Netflix Jumps After Smashing Subscriber Expectations, Unveils $17 Billion In Content Commitments

After some initial confusion, Netflix stock surged after hours, a repeat of what it did last quarter, soaring above its all time high price, up over 2% after reporting Q3 numbers which while beating slightly on revenues ($2.99Bn, Exp. $2.97Bn), and beating modestly on non-GAAP EPS (GAAP EPS$0.29, non-GAAP EPS $0.37, exp. $0.32), were far more remarkable for the subscriber numbers, which smashed expectations as follows:

  • Q3 total net streaming additions 5.3 million, Exp. 4.5 million
    • Q3 domestic net streaming additions 850,000, exp. 774,000
    • Q3 international net streaming additions 4.45 million, exp. 3.72 million

The addition of 5.2 million subs in Q2 was the largest increase ever during the period, which traditionally is among the company's slowest time of year.

Netflix' Q4 outlook was in line with expecations and the company now expects Q4 net streaming adds of 6.3 million (1.25m in the US and 5.05m internationally) just fractionally higher than the consensus estimate of 6.29 million and below the 7.05 million in the year ago quarter (which was the company's all time record high quarter).

The company expects $3.27 billion in Q4 revenue, also above the consensus estimate of $3.15 billion, generating net income of $183 million.

One thing that investors will focus on is the company's content spend for next year, which Netflix is increasing once again: having previously said they would spend $7 billion, they are raising that by as much as a $1 billion, forecasting that "we’ll spend $7-8 billion on content (on a P&L basis) in 2018."

Also, it will come as no surprise that with Wall Street expecting the company to spend $8.7 billion this year on content...

... it will continue spending an ungodly amount. Netflix now has 109.2 million subscribers worldwide, but the success has come at a steep price and as of Sept.30, NFLX's total content obligations were a record $17 billion.

The company's historical content spending is as follows:

  • 2018: $7-$8 billion (forecast)
  • 2017: $6 billion
  • 2016: $5 billion
  • 2015: $4 billion
  • 2014: $3 billion
  • 2013: $2 billion

Also, as one would expect, the company remains in its near-record cash burning ways, reporting that in Q3 it burned $464 million, modestly below the $608 million it burned last quarter, and $506 million one year earlier.

Discussing its relentless cash burn, Netflix said its negative FCF, that despite growing operating income, "is due to growth of our content spend, original content in particular, where we pay for the titles before consumers enjoy the content, and the asset is amortized by estimated viewing over time. We anticipate financing our capital needs in the debt market as our after-tax cost of debt is lower than our cost of equity."

Below are some more highlights from Netflix' letter, first focusin on subscribers:

Global streaming revenue in Q3 rose 33% year over year, driven by a 24% increase in average paid memberships and 7% growth in ASP. Operating income nearly doubled year-over-year to $209 million with our Q3 global operating margin of 7.0% putting us right on track to achieve our full year target of 7%. EPS of $0.29 included a pre-tax $51 million non-cash loss from F/X remeasurement on our Euro bond (or $39 million after tax based on a 24% tax rate). Higher than expected excess tax benefit from stock based compensation benefited our tax rate by $5 million vs. our forecast. As a reminder, the quarterly guidance we provide is our actual internal forecast at the time we report. We added a Q3-record 5.3 million memberships globally (up 49% year-over-year) as we continued to benefit from strong appetite for our original series and films, as well as the adoption of internet entertainment across the world. Relative to our guidance of 4.4 million net adds, we under-forecasted both US and international acquisition. Year to date net adds of 15.5 million are up 29% versus last year.

On the the domestic vs international margin, and why the first missed while the second beat:

Domestic contribution margin in Q3 of 35.8% vs. 36.4% last year was below our forecast of 37.1% due primarily to the earlier-than-anticipated close of certain content deals. The foreign currency impact in the quarter was +$13 million and Q3 international revenue grew 54% year over year, excluding currency. F/X-neutral ASP increased 7.4% year over year. International contribution profit margin of 4.7% exceeded our 2.3% guidance, also due to the timing of content deals.

On the company's guidance:

For Q4, we forecast global net adds of 6.30m (1.25m in the US and 5.05m internationally) vs. 7.05m in the year ago quarter (which was our all-time high for quarterly net adds). We recently announced price adjustments in many markets to our HD and 4K video plans while keeping our SD plan mostly unchanged (still $7.99 in the US, for instance). Existing members will be notified and their prices will be adjusted on a rolling basis over the next few months. Increased revenue over time will help us grow our content offering and continue our global operating margin growth.

Here is the warning that the company's contribution margin will decline as it focuses on marketing:

We’ve been focused on growing global operating margin as our primary profitability metric since hitting our 2020 US contribution margin goal of 40% this past Q1. This allows us to avoid near term optimization for specific domestic or international contribution margin targets which could impede our long term growth. For instance, we anticipate our Q4’17 US contribution margin will be 34.4% (a decline both year-on-year and sequentially) as we boost our marketing investment against a growing content slate. We spend disproportionately in the US to generate media and influencer awareness for our programming which we believe, in turn, is an effective way to facilitate word of mouth globally. In our international segment, we are on track to generate positive contribution profit for the full year. As we move into 2018, we aim to achieve steady improvement in international profitability and a growing operating margin as our success in many large markets helps fund investments throughout Asia and the rest of the world.

Perhaps most important, is the discussion of the Netflix content portfolio and the gargantuan content commitments:

Investors often ask us about continued access to content from diversified media companies. While we have multi-year deals in place preventing any sudden reduction in content licensing, the long-term trends are clear. Our future largely lies in exclusive original content that drives both excitement around Netflix and enormous viewing satisfaction for our global membership and its wide variety of tastes. Our investment in Netflix originals is over a quarter of our total P&L content budget in 2017 and will continue to grow. With $17 billion in content commitments over the next several years and a growing library of owned content ($2.5 billion net book value at the end of the quarter), we remain quite comfortable with our ability to please our members around the world. We’ll spend $7-8 billion on content (on a P&L basis) in 2018.

On competition and usage, where everyone is jumping in:

Since 2013, we’ve taken the Long Term View that we’re in the early stages of the worldwide, multi-decade transition from linear TV to internet entertainment. Recently, it’s been unfolding right before our eyes: Disney announced plans to launch direct-to-consumer services for ESPN and its other brands, cable network owners are licensing their channels to virtual MVPDs like Hulu, YouTube, Sling TV, and DirecTV Now, CBS’ All Access is expanding internationally, Apple is reportedly planning on spending $1 billion on original content and Amazon is streaming NFL games while its Prime Video service has gone global. Facebook launched its Watch tab for original videos. At the same time, linear TV networks like MTV, A&E and WGN are cutting down on scripted series. Last year, the number of original scripted series on linear TV (across broadcast, premium and basic cable) began to decrease as online services ramped up activity.

Finally, on cash burn:

Free cash flow in Q3 totaled -$465 million vs. -$506 million last year and -$608 million in Q2’17. There is no change to our expectation for FCF of -$2.0 to -$2.5 billion for the full year 2017. Negative FCF, despite growing operating income, is due to growth of our content spend, original content in particular, where we pay for the titles before consumers enjoy the content, and the asset is amortized by estimated viewing over time. We anticipate financing our capital needs in the debt market as our after-tax cost of debt is lower than our cost of equity.

Judging by the afterhours stock response , investors are far less worried about the relentless cash burn, and the $17 billion in already accrued content commitments, and instead are are more impressed with the subscriber additions, as a result sending the stock over 2% higher.

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