Netflix Soars 20% As Subscribers Smash Expectations But Cash Burn Explodes

There was some long overdue good news for Netflix longs, when moments ago NFLX reported that in Q3 revenue and EPS of $2.29 billion and $0.12 beat expectations of $2.28 billion and $0.06 respectively. But the reason why the stock is surging 20% after hours is because the growth appears to be back as a result of a surge in Q3 streaming subscribers, which jumped by370K domestically and 3.2million internationally, far above the 300K and 2.0 million expected.

For Q4 the company now expected 3.75 million net international streaming subs, a substantial jump from Q3 if modestly below the 4.04 million in Q4 2015, while NFLX expects 1.45 million domestic net adds, also fractionally below last year's 1.56 million. This is how NFLX explained the solid jump in subscribers:

In Q3, we added 0.4 million members in the US vs. our forecast of 0.3 million and 3.2 million members internationally vs. our forecast of 2.0 million. Our over-performance against forecast (86.7m total streaming members vs. forecast of 85.5m) was driven primarily by stronger than expected acquisition due to excitement around Netflix original content.


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, we under forecasted member growth, while in Q2, it was the opposite. For the first nine months of 2016, we’ve added 12 million global members, the same as in the first nine months of 2015.


By the end of Q3’16, we had un-grandfathered 75% of the members that are being un-grandfathered this year and the impact has been consistent with our expectations. ASP grew over 10% year-over-year in both the US and international segments (excluding a $35 million F/X impact). With more revenue, we can reinvest to further improve Netflix to attract new members from around the world, while continuing to delight our existing customers.


Domestically, revenue rose 23% year over year, 480 basis points faster than Q2. US marketing expense rose as a percentage of revenue as we spent to build awareness for our expanding number of original titles. US contribution profit increased 38% year-over-year with contribution margin expanding to 36%, slightly ahead of our 35% forecast.


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In the international segment, we exceeded our internal projection for net adds as the acquisition impact of our originals was greater than anticipated across many of our markets. F/X-neutral revenue rose 72% and international contribution loss was flat sequentially at $69 million as content costs came in under our forecast due partly to timing. We are investing in more content across multiple international markets in Q4 and, as a result, we project international contribution loss to grow moderately to $75 million.


In September, we localized Netflix in Poland and Turkey. We began accepting payment in local currency and added a local language user interface, subtitles and dubbing as well as some local content. We have seen nice gains in viewing and retention and we’ll undertake other localization efforts in the coming months and years.


For Q4, we forecast 5.2 million global net adds, with 1.45 million net adds in the US and 3.75 million new members internationally. Our expectation for a moderate year-over-year decline in net adds reflects the completion of un-grandfathering. We are pleased with the results thus far as we expect ASP to grow 12% from Q1’16 to Q4’16. Internationally, the initial demand from our launch in Spain, Portugal and Italy in Q4’15 will also affect our year-over-year net adds comparison.

Netflix did however warn that after Q4 it will "face a tough international net adds comparison in Q1’17 because of the initial membership surge in Q1’16 tied to the launch of 130 additional territories. As discussed, for the balance of 2016, we will continue to operate around break even, and then start generating material global profits in 2017 and beyond, by marching up operating margins steadily for many years."

It also warned on China, saying that "the regulatory environment for foreign digital content services in China has become challenging. We now plan to license content to existing online service providers in China rather than operate our own service in China in the near term. We expect revenue from this licensing will be modest. We still have a long term desire to serve the Chinese people directly, and hope to launch our service in China eventually.

But while the subscriber growth was admirable, the biggest problem facing NFLX, its cash burn just went into overdrive in Q3, with the company reporting that cash burn for the quarter doubled from $254 million to over half a billion, or $504 million, most of it the result of the spike in original produced content. This is how it explained the jump:

In Q3, free cash flow was -$506 million vs. -$254 million in Q2’16 and -$252 million in the year ago quarter. The increase in our free cash flow deficit reflects the growth of original content, which we are increasingly producing and owning (rather than licensing). Self-produced shows like Stranger Things require more cash upfront as we incur spending during the creation of each show prior to its completion and release. In comparison, we generally pay on delivery for licensed originals like Orange is the New Black and we pay over the term of the agreement for licensed non-originals (eg, Scandal).


Over the long run, we believe self-producing is less expensive (including cost of capital) than licensing a series or film, as we work directly with the creative community and eliminate additional overhead and fees. In addition, we own the underlying intellectual property, providing us with global rights and more business and creative control. Combined with the success of our portfolio of originals and the positive impact on our member and revenue growth, we believe this is a wise investment that creates long term value. Consequently, we plan on investing more, which will continue to weigh on free cash flow. We expect Q4’16 FCF to be similar to Q3’16 FCF. Over time, we will be able to fund more of our investment in programming through the growth in operating profit and margin already underway.


Streaming content obligations at quarter end were $14.4 billion, up $1 billion sequentially. The increase reflects the addition of both new original and non-original content to our library as well as expanded rights for our new territories.


We finished the quarter with $1.3 billion in cash and equivalents. As we have often done over the past few years, we plan to raise additional debt in the coming weeks. With a debt to total capitalization ratio of about 5%, we remain underleveraged compared both to similar firms and to our view of an efficient capital structure. Our 2025 bonds continue to trade well .

This is what NFLX's cash burn looks like as of Q3. As of Q3, the company had burned through $1.3 billion in cash which explains why, as the company admitted, "we plan to raise additional debt in the coming weeks"

But the cash burn in a simpler context, it cost NFLX $142 in cash to add one subscriber in the third quarter.

For now, however, the reason why the shorts are being massively squeezed is due to the return to a "growth" mode, one which cost the company over half a billion in cash in the quarter, and the immediate result is a 20% surge in the company stock after hours.

At some point the relentless cash burn will matter, but not right now.