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  1. Home
  2. / Investing
  3. / Stocks

Netflix's Newest Drama: Its Q2 Earnings

As Netflix dropped following a subscriber miss revealed in its quarterly report on late Wednesday, key challenges emerged: declining net income, slowing membership growth and increased competition from Disney and others.
By DAVE BUTLER
Jul 17, 2019 | 06:21 PM EDT
Stocks quotes in this article: NFLX, DIS, CMCSA, T

Netflix (NFLX) stock is down around 10% in after-hours trading -- at the time of this writing -- after reporting fiscal second quarter 2019 results that displayed some slowing in user growth, coupled with continued weak cash flow.

Part of the reason this quarterly release is causing such a reaction from shareholders is the rising competition. Netflix no longer has all the time in the world. Names like Disney (DIS) and Comcast (CMCSA) are eyeing up the streaming market, too.

Netflix reported revenue growth of 26% to $4.92 billion. This growth rate pales in comparison to the second quarter of 2018, when revenues grew by 40.3%. Operating margins were stronger at 14.3%. That operating income of $706 million was the company's highest in the past five quarters. Unfortunately, that operating income did not translate into higher net earnings. Net income was $271 million compared with $384 million in the second quarter of 2018. On a per share basis, Netflix reported earnings of 60 cents per diluted share.

I'm not sure what the markets care more about: the declining net income, or the slowing membership growth. Paid streaming membership growth increased by 21.9% to 151.56 million users. That's slower than usual. Between 2018's second quarter and this year's first, paid memberships were growing at well over 25% per quarter.

Free cash flow was once again negative, with a decrease in cash of $594 million. Netflix continues to spend on content and expansion, which is basically cannibalizing anything it does on the income statement. For a long time, that was okay, as investors believed that the long game would justify it all. But, as user growth slows, and the competition mounts, I think we're going to see more pressure.

I've written about my belief that competition from Disney is going to ruin the Netflix story before. I didn't anticipate how quickly everyone else would jump in on the game as well. The original genius of Netflix, to me, was how smoothly it acquired streaming deals for other companies' content. Shows like "The Office," movies like "The Avengers" -- all this stuff was on there and available.

Netflix was gaining access to a huge consumer base, all at the cost of those who were providing their content for its use. Sure shows like "House of Cards" and "The Crown" increased the reputation of Netflix, and garnered critical acclaim and demand, but the beauty of the original Netflix formula was how it essentially served as a middleman for content viewing.

Now, as shows like "The Office" are getting pulled, and companies like Disney work to harbor their incredibly diverse and vast library of content for its own uses, Netflix is going to face an even bigger crunch for original content. To that end, it's very likely that cash flow could get worse. If all these names like Comcast's NBCUniversal, Disney with Hulu and the upcoming Disney plus, AT&T (T) through TimeWarner, all start competing for streaming market share on a grand scale, I think Netflix stock is going to face a lot of downward pressure.

It would be different if Netflix's stock traded at a decent valuation. NFLX is expensive; trading at more than 100-times trailing full-year earnings. For the full year, Netflix is still forecasting free cash flow to decrease by $3.5 billion. The company has always said that as it increases its member base, this cash-flow deficit will right itself. To me, that's an unproven claim. To pay such a high premium for a stock, you have to ask yourself: Will the company be able to maintain its growth rates in a market with more competitors? And, will it be able to do it without damaging margins?

The company is forecasting paid membership growth of 21.6% in the third quarter; again lower than the year prior. On the bright side, it is projecting an increase in earnings per share to $1.04.

The battle for streaming is only going to intensify, and as that competition rises, it feels foolish to be paying such a high premium for NFLX stock. I rate NFLX as a "sell." The risk/reward just isn't there.

Comcast and Disney are holdings in Jim Cramer's Action Alerts PLUS member club.

Get an email alert each time I write an article for Real Money. Click the "+Follow" next to my byline to this article.

At the time of publication, Dave Butler had no position on the securities mentioned.

TAGS: Entertainment | Earnings | Investing | Stocks | Digital Entertainment | Technology | Technology Hardware & Equipment

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