Netflix stock has surged after hours, soaring above its all time high price, and up nearly 10% after reporting Q2 numbers which while beating slightly on revenues ($2.79Bn, Exp. $2.77Bn), and missing on EPS ($0.15, exp. $0.16), were far more remarkable for the subscriber numbers, which smashed expectations as follows:
- Q2 total net streaming additions 5.2 million, Exp. 3.27 million
- Q2 domestic net streaming additions 1.07 million, exp. 633K
- Q2 international net streaming additions 4.14 million, exp. 2.63 million
The addition of 5.2 million subs in Q2 was the largest increase ever during the period, which has traditionally been the company’s slowest time of year. That said, Netflix was quick to moderate the exuberance that these number would create and warned that “there was lumpiness in net adds, likely due to demand being pulled forward.”
Netflix’ outlook was also well above expecations and the company now expects Q3 net streaming adds of 4.4 over 400K more than the consensus estimate of 3.99 million. The company expects $2.97 billion in Q3 revenue, also above the consensus estimate of $2.88 billion, and net income of $143 million, above the est. $101.6 million.
The company now has 104 million subscribers worldwide, but the success has come at a steep price and as of March 31, NFLX’s total content obligations were $15.3 billion, a number which has likely increased by about a billion dollars in the latest quarter.
Less impressive were the financials: here operating margin tumbled from 9.7% in Q1 to 4.6% in Q2 as a result of a $245 million sequential increase in cost of revenues.
Furthermore, the company is back to its record cash burning ways, reporting that in Q2 it burned a record for the quarter $608 million, just why of its worst cash burn quarter in history when it burned $639 million in Q4 of 2016.
The highlights from Netflix’ letter:
In Q2 we underestimated the popularity of our strong slate of content which led to higher-than-expected acquisition across all major territories. As a result, global net adds totaled a Q2-record 5.2 million (vs. forecast of 3.2m) and increased 5% sequentially, bucking historical seasonal patterns. For the first six months of 2017, net adds are up 21% year-on-year to 10.2m. Our Q3 guidance assumes much of this momentum will continue but we are cognizant of the lessons of prior quarters when we over-forecasted and there was lumpiness in net adds, likely due to demand being pulled forward (into Q2 in this case).”
On the subscriber sides, Netflix had this to say:
Domestic net additions of 1.1m represented the highest level of Q2 net adds since the second quarter of 2011. For Q3’17, we project that we will add 0.75m US members, compared with 0.37m in Q3’16, which was impacted by un-grandfathering. Our international segment now accounts for 50.1% of our total membership base.
International revenue rose 57% year over year, excluding a -$23 million impact from foreign exchange, while international ASP grew 10% year over year on a F/X neutral basis. International contribution profit of -$13 million vs. -$69 million was better than our -$28 million forecast due primarily to higher-than-forecasted paid members.
We’re forecasting Q3’17 international net adds of 3.65 million. We are making good progress with our international expansion as improving profitability in our earlier international markets helps fund significant investment in our newer territories. As a result, we expect positive international contribution profit for the full year 2017 at current F/X exchange rates. This would mark the first ever annual contribution profit from our international segment.
On the collapse in margins:
For Q2, global streaming revenue was within 1% of our projection. As expected, operating margin dipped 516 basis points sequentially due to the timing of content releases, and came in at $128m on forecast of $120m. Through the first half of 2017, our operating margin was 7.1%, putting us on track for our full year target of 7%, which we plan on growing in 2018 and beyond. Q2 EPS was on target at $0.15, as a greater than expected tax benefit offset a -$64 million non-cash unrealized loss from our euro bond (which was recognized in our P&L in interest and other income/expense).
On its content portfolio:
Last week, the Television Academy nominated 27 Netflix original programs with 91 Emmy nominations, nearly double last year’s tally. With five of the 14 total nominated best series contenders (Stranger Things, The Crown, House of Cards, Master of None and Unbreakable Kimmy Schmidt), Netflix had the most nominated series of any network. We are proud that even as we have increased our volume of originals across several genres, we continue to grow the recognition for the quality of those shows, including brand new series like Stranger Things and The Crown, which will have second season premieres in 2017.
We understand that our approach to films – debuting movies on Netflix first – is counter to Hollywood’s century-old windowing tradition. But just as we changed and reinvented the TV business by putting consumers first and making access to content more convenient, we believe internet TV can similarly reinvigorate the film business (as distinct from the theatrical business). This year we will release 40 features that range from big budget popcorn films to grassroots independent cinema.
On competition and usage:
The competition for entertainment time is always intense, but the silver lining is that the market is vast and diverse. YouTube is earning over a billion hours a day of consumers’ time with one type of entertainment, while we are earning over a billion hours a week with our type of entertainment. Linear TV is still huge, piracy still substantial, and there are thousands of firms and approaches around the world earning some fraction of consumers’ entertainment time. The entertainment market is so broad that we’ve grown from zero to over 50m streaming households in the US over the last 10 years, and yet HBO continues to increase its US subscriptions. It seems our growth just expands the market. The largely exclusive nature of each service’s content means that we are not direct substitutes for each other, but rather complements.
… The internet may not have been great for the music business due to piracy, but, wow, it is incredible for growing the video entertainment business around the world.
Finally, on cash burn:
Q2’17 free cash amounted to -$608 million vs. -$254 million in the year ago quarter and -$423 million in Q1’17. We anticipate free cash flow of -$2.0 to -$2.5 billion for the full year 2017. With our content strategy paying off in strong member, revenue and profit growth, we think it’s wise to continue to invest. In continued success, we will deploy increased capital in content, particularly in owned originals, and, as we have said before, we expect to be FCF negative for many years. Since our FCF is driven by our content investment, particularly in self-produced originals, we wanted to provide some additional context on our content accounting at our investor relations website.
We continue to debt finance our capital needs as we believe this reduces our weighted average cost of capital, resulting in a more efficient capital structure. In May, we completed a 1.3 billion euro bond offering. In addition to a small natural hedge to our growing European revenues, we are pleased to have broadened our access to capital markets beyond the US high yield market. Our euro bond may add some volatility to our net income as each quarter we remeasure the liability on our balance sheet based on the quarter end euro-to-dollar exchange rate. As a reminder, quarter-to-quarter remeasurement changes in this liability are reflected as a non-cash unrealized gain (loss) below operating income in “interest and other income/expense” in our P&L (-$64 million impact on net income in Q2’17).
The afterhours response shows that investors are far less worried about the relentless, near record cash burn, and instead are are more impressed with the subscriber additions, as a result sending the stock nearly 9% higher.