Netflix (NFLX) reported a strong fourth quarter in regards to revenue growth, as well as user growth. I just can't get over how much it is costing them to do it.
Revenues increased 27.4% year over year to $4.19 billion. That's a bit slower than last year's 32.6% growth. Operating margins also fell a bit; coming in at 5.2% vs. 7.5% in fourth quarter 2017. Net income dropped 27.9% to $134 million; while diluted earnings per share decreased 26.8% to $0.30 a share. The costs caught up a bit this quarter; demonstrating the expensive nature of the content and marketing that Netflix is employing to drive its user growth. And indeed, that user growth remains strong. Paid memberships increased 25.9% year over year vs. growth of 24.2% last year. Until now, the market has seemed to drive Netflix shares based on that user growth. Interestingly enough, the stock is down in after-hours trading post earnings repot. Are investors finally starting to value this thing based on its actual earnings? It's too early to tell.
I think what's spooked the stock a bit is the first quarter 2019 guidance. Netflix expects revenue growth of 21.4% in the first quarter of 2019. That's roughly half the growth obtained in first quarter 2018. It also forecasts operating margins of 8.9% and diluted earnings of $0.56. Those are both decreases versus first quarter 2018. Netflix expects membership growth of 24.6% in the first quarter compared to 26% last year. Is that a big difference? Not really; but it certainly isn't what investors want to see.
I still can't bring myself to get past the amount of cash they burn, coupled with the mounting competition against them. Free cash flow fell $1.315 billion in the fourth quarter. For the year they burned around $3 billion. It's not a super surprise considering they basically told us ahead of time what to expect. In the fourth quarter release, the company also forecasts 2019 to have a similar cash burn before finding positive free cash flow in 2020. I'm not sure it's going to be that easy. There's a lot happening with competition right now that might force Netflix to spend even more on content. Don't get me wrong. They have some great shows. They're just paying an arm and a leg to make them.
For Netflix to succeed, it has to be well ahead of its developing rivals and they are most definitively on their way. NBC most recently announced it would dive into the fray with its own free streaming service for anyone with a pay TV service. A subsidiary of Comcast (CMCSA) , one has to wonder whether this will result in NBC pulling a lot of its shows and Universal movies from Netflix's portfolio. Furthermore, it will bolster consumers that pay for regular view cable, as they'll get NBC's service for free. Those who don't have pay-TV will likely be charged $12 a month.
I view Disney (DIS) as the biggest threat and actually the best investment. Their strong track record of creating incredibly profitable content is something that Netflix cannot boast. Disney is about to have a majority stake of Hulu once its acquisition of Fox assets is finalized. I believe the ramifications of that ownership will be huge. Disney will undoubtedly up the ante on Hulu's content creation and deal making once they have a higher incentive for it to succeed. Even now, the company is making waves.
Ad sales increased 45% in 2018, bringing the company's revenue to over $1.5 billion; though the company still lacks earnings. Subscribers increased 48% year over year to 25 million. Obviously the streaming service is still small compared to Netflix, but the rising involvement of Disney could change everything. They know how to build. They know how to market. They know how to conquer. I expect to see huge content expansion under their helm. They have the capital and production capabilities to make it a true threat to Netflix.
As more and more companies get involved with streaming, I think it will put immense pressure on Netflix's content. Disney is planning its own streaming service on top of its stake in Hulu. I find it highly unlikely that the company will allow its content portfolio to be streamed on Netflix. The content "war" that I believe is ahead of us will force Netflix to have ever higher levels of original shows and movies. To that end, their cash position will get more pressured.
It's a balancing act. Can Netflix keep driving its content business, while finding positive cash flow? The subscription price raise to $13 that was recently announced will certainly bolster revenues, but that can only be done so many times. As multiple streaming services develop, there will be pricing competition. Can Netflix compete on price while still being able to drive content? They're unproven on this front. Finishing the year with $2.68 in diluted earnings, the stock is trading at 130x full year earnings, with a projected earnings decline in Q1'19. I much prefer something like Disney given the valuations.
