Probably one of the most closely watched equities out there; Netflix (NFLX) reported third quarter earnings results that have the stock up nearly 12% in after-hours trading. Hits on revenue and a beat on earnings are positive news, but the stock surge is almost definitely more about the climb in user growth. New subscribers beat out estimates in both domestic and overseas markets. As a whole, I still worry about debt levels and the general cash flow situation. The company is spending a lot of money in order to drive the growth of its business.
Stronger User Growth
We all watched the stock crater after second-quarter results gave investors a less than desirable slowdown in overall user growth. The stock was driven down despite a 40% jolt in revenues. The entire growth story for Netflix has been predicated on the idea that they could derive massive user engagement that would counter the big debt financing that the company has used to build its content. The third-quarter marked a return to much better user growth. Total subscribers increased by 6.96 million. That's a 31.3% increase over last year's 5.3 million. As a comparison, Q2'18 user growth actually slowed to 5.15 million new subscribers vs. 5.2 million in Q2'17.
It cannot be overstated how important this user growth was for Netflix. The stock would likely have experienced severe fallout had user growth come up stagnant again. Forecasts for the fourth quarter are more upbeat as well; with an estimated 9.4 million in new subscribers expected in Q4 vs. 8.33 million in Q4'17.
Revenues increased 34% to just under $4 billion. Operating margins were 12% versus 7% in Q3'17 on operating income of $481 million. Net income increased 210% to $403 million. Clearly a big gain, the income broke down to $0.89 per share versus a $0.68 estimate. I kind of think of Netflix's earnings as "faux money." The company does produce earnings per share, but they don't come close to covering the financing activities that keep the business growing.
Cash flow is actually getting worse as the company spends even more on content. Free cash flow for the third quarter was -$859 million compared to -$465 million a year ago. With estimates of full year cash flow around -$3 billion, the company expects the deficit to expand in the fourth quarter relative to the third. I worry that Netflix faces a situation where it has to spend too much in order to keep expanding. The draw of the service is the quality of its content; but that content seems to cost more to make than Netflix can actually get out of it in returns. It just doesn't show in the earnings, as the company uses other means to pay for it.
I worry we're watching shows we can't really pay for
If you take a look at their operating cash flow, income of $402.8 million doesn't come close to covering the $3.2 billion in cash used for additional content. Cash from operating activities ran a deficit of $690.4 million. All of this is based on the content being able to drive the subscriber base high enough to pay for itself from revenue. My question is simple. What if that doesn't happen? The competitors are growing rapidly for Netflix's business model, and I worry that Netflix is going to rack up a bunch of liabilities for a business that will lose its edge. Hulu (among others) is garnering more and more attention as Disney (DIS) consolidated more ownership of the streaming service. Disney is also planning its own streaming service. This is going to force Netflix to spend more on original content, as rivals will certainly not give theirs up without a big premium. Competitors will also begin to cut into Netflix's user growth. That's a real problem, as they still need more users in order to pay for the high cost of their content.
Simply put, I don't think Netflix is deriving enough from its business. I am very concerned that any threat to user growth will derail the train. The company is up to $8.3 billion in long term debt, and almost has to keep spending money to keep gaining subscribers. That'll come out of their balance sheet, as there isn't enough coming from the income statement. It's okay now, as they have over $3 billion in cash on hand. But if at any point they're challenged by competitors on user growth, it doesn't seem like the financial statements have what will be needed to fund their shows. Unless they up prices, they need more and more users. The stock is up big now off the news of user growth and profitable earnings; and it falls in line with the view I took a while ago that Netflix could get over $400 a share.
Long term, I'm much less bullish. I love the service. I love the content. But we the consumer are not actually paying enough money for Netflix to finance that content from operating income alone. It's a problem that isn't getting as much attention as it should.