Netflix Surges Despite Missing On Total Subs, Huge Guidance Miss

Last quarter, when Netflix subscriber growth hit a brick wall and US subs actually declined, we asked "is the Netflix growth juggernaut finally dead?" It now appears that that may be the case, because in its just released Q3 letter, Netflix said it will add 26.7 million customers this year, fewer than it added last year, and the first annual drop in growth this decade.

Back in April, when Netflix reported strong Q1 earnings, what surprised most investors was the company's unexpectedly weak outflook, predicting a sharp slowdown in subscriber growth, with roughly 5 million in new subscriber adds. Then one quarter ago, the outlook got even worse when subscriber growth plunged as Netflix reported that in Q2 it added a tiny 2.7 million subs, far below the company's own 5 million forecast and the lowest increase in three years.

Fast forward to today, when moments ago Netflix reported a mix of good, neutral and bad news.

First, the good news: NFLX reported Q3 revenue and EPS of $5.24BN and $1.47, both roughly in line with expectations of $5.25BN and $1.05; The neutral (to bad) news was Q3 global streaming subs rose by 6.77MM, missing both the company's estimate of 7 million and Wall Street's 6.8 million estimate. Of those, 520,000 came from the U.S., while 6.3 million came from abroad, modestly above the 6.2 million estimate. In other words, Q3 domestic growth missed, while international growth was slightly better than expected, which appears to be the narrative pushed by the bulls to push the stock sharply higher after hours.

And while investors focus on the tiny beat in international subs in Q3, it's worth reminding NFLX shareholders that the real money comes from the US, where Netflix is going to post its weakest growth in years, adding just 2.7 million customers. Why the hit to growth? NFLX blamed its latest price increase.

Meanwhile, that NFLX now expects Q4 revenue of $5.442BN, also below the consensus estimate of $5.51BN, and Q4 EPS of 51 cents, below the 82 cent estimate.

But the bad, or rather worse, news was that the company's guidance was again dismal, with the company now expecting the following Q4 growth:

  • Total streaming net subs +7.6MM, a nearly 20% miss to the Exp. 9.32MM
    • Domestic subs +600,000, half the +1.28 million consensus estimate
    • International subs +7.0 million, also far shy of the consensus 8.04 million estimate

Big miss in Q4 growth guidance notwithstanding, Netflix decided to pat itself on the back for missing Q3 subs by "only" 200K: This is what Netflix said:

Total paid net adds of 6.8m increased 12% year over year and was an all-time Q3 record. As a reminder, the quarterly guidance we provide is our actual internal forecast at the time we report and we strive for accuracy. In Q3, our guidance forecast was our most accurate in recent history.

Accurate it may be, the problem is that not only is it missing (badly or not so badly), it is clearly slowing as the following chart shows, which more importantly shows that NFLX missed its own subscriber guidance for 2 quarters in a row after beating 7 of the past 8.

Some more of Netflix's own observations:

In the US, paid net adds totaled 0.5m in Q3 vs. our 0.8m forecast, and year to date paid net adds are 2.1m vs. 4.1m in the first nine months of 2018. Since our US price increase earlier this year, retention has not yet fully returned on a sustained basis to pre-price-change levels, which has led to slower US membership growth. On a member base of more than 60m, very small movements in churn can have a meaningful impact on paid net adds. However, revenue growth has been accelerating as US ARPU increased 16.5% year over year in Q3. With more revenue, we’ll continue to invest to improve our service to further strengthen our value proposition.

International paid net additions totaled 6.3m in Q3, a 23% increase vs. 5.1m in the year ago quarter, and slightly above our 6.2m guidance forecast. The US dollar strengthened vs. several key currencies over the course of the quarter, which resulted in the variance between our forecasted vs. actual international revenue. International ARPU, excluding the impact of F/X, rose 10% year over year. We’re making strides in our key markets and, while we have much more work to do in Asia in the coming years, we are seeing encouraging signs of progress.

In case it still isn't clear that Netflix's best days are behind it, the company conveniently provided the following chart showing global paid net adds YTD, which is now lagging 2018 despite continued massive spending to expand in the international market. Said otherwise, Netflix now believes it will add only 26.7 million customers this year, fewer than it added last year, and the first drop in growth in a very long time.

Previously, Netflix had expected to add more subscribers this year than last year, but - as shown above - now says that's unlikely. The reasons:

  • New big IP launches (as opposed to returning seasons)
  • People canceling due recent price increases
  • New streaming competition (see Disney+, HBO Max, etc.)

And just so Apple isn't the only "growth" company to slash various reporting metrics, Netflix joined in and announced that it would stop differentiating between domestic and international margins, to wit:

"as we self-produce and license more original content that has global rights, we are finding US segment contribution margin reporting is becoming less useful internally. We’ll stop reporting on it in January 2020 and continue to focus on global operating margin as our primary profitability metric"

What was left unsaid is that international margins clearly are not growing nearly fast enough, but hey, "it's less useful internally."

So why despite another big miss on guidance and a clear slowdown to its growth, is the company soaring after hours? Because, i) the company's international subs in Q3 did beat by a tiny fraction, and ii) the narrative goes, the company is now focusing more on profit and viability.

Is it? This is what Netflix said:

For Q4, we’re expecting consolidated revenue to increase 30% year over year with 9% streaming ARPU growth. We’re forecasting 7.6m global paid net adds (vs. 8.8m last Q4), with 0.6m in the US and 7.0m for the international segment. This implies full year 2019 paid net adds of 26.7m, down from 28.6m last year. While we had previously expected 2019 paid net adds to be up year over year, our current forecast reflects several factors including less precision in our ability to forecast the impact of our Q4 content slate, which consists of several new big IP launches (as opposed to returning seasons), the minor elevated churn in response to some price changes, and new forthcoming competition. As we outline in more detail below, our long term outlook on our business is unchanged.

That's great, there is just one problem: cash burn was barely changed, and the company burned through $551 million in Q3, and has now burned money for 21 consecutive quarters, with Free Cash Flow since Q3 2014 a total of $9.4 billion.

As the company itself states, "free cash flow in Q3 totaled -$551 million vs. -$859 million in Q3’18. For the full year 2019, we’re still expecting FCF of approximately -$3.5 billion." There was some good news: NFLX says it is now "expecting free cash flow to improve in 2020 vs. 2019 and we expect to continue to improve annually beyond 2020. As we move slowly toward FCF positive, our plan is to continue to use the high yield market in the interim to finance our investment needs."

But while Netflix's lack of profitability and relentless cash burn is well known, the biggest risk facing the company now is competition, as Apple, HBO, NBC and Disney are set to join the Amazon, YouTube and Hule juggernaut. This is what Netflix said:

Many are focused on the “streaming wars,” but we’ve been competing with streamers (Amazon, YouTube, Hulu) as well as linear TV for over a decade. The upcoming arrival of services like Disney+, Apple TV+, HBO Max, and Peacock is increased competition, but we are all small compared to linear TV. While the new competitors have some great titles (especially catalog titles), none have the variety, diversity and quality of new original programming that we are producing around the world.

That remains to be seen, although one thing is clear: with the competitors offering their product in the single-digits, Netflix will have its hands full trying to keep its subscribers from fleeing, something Netflix co-founder Mark Randolf told CNBC after the earnings release.

Bottom line: Netflix still thinks of itself as so "small", the market can easily accommodate more streaming providers. Considering the increasingly dismal state of US consumer finances, that may be a huge gamble that NFLX shareholders probably should consider not making.

Perhaps sensing the upcoming challenge Netflix was surprisingly honest about what is coming:

The launch of these new services will be noisy. There may be some modest headwind to our near-term growth, and we have tried to factor that into our guidance. In the long-term, though, we expect we’ll continue to grow nicely given the strength of our service and the large market opportunity.

Yet despite virtually no positive inflection point to the business, and if anything, a continued slowdown to growth, not to mention an imminent influx of competitors as both Disney, and Apple are about to unleash their own product offering and steal Netflix' market share, the stock is surging as much as 10% after hours.

Somehow we doubt that this violent short squeeze will be sustainable as the race to the pricing bottom of the content wars costs Netflix first users, and then revenues. Finally, here is the after hours move in context for a company which is about to become the whipping boy for several far bigger, far more profitable and far better capitalized competitors.