Netflix Earnings: It's More About What The Company Is Not Doing

| About: Netflix, Inc. (NFLX)

Summary

Netflix's projected net adds growth is inflated by a low base from last year's un-grandfathering.

3 million is merely a return to normal. 4 million would be a true breakout.

Concern over account sharing and free trials is overblown, and any attempt to crack down will likely do more harm than good.

Netflix's high P/E is somewhat deceiving, since its profits are suppressed by international costs and margins should rise going forward.

Provided there is no movement away from Netflix's current sensible policies on these issues, I remain bullish on the stock.

Netflix (NFLX) is reporting earnings today after closing, and as usual speculation is focusing on Netflix’s subscriber numbers. While I agree growth statistics are very important, I also want to flag a few other things investors should watch for in the report and the subsequent conference call. As important as re-assuring ourselves that Netflix is doing the things it’s supposed to be doing is re-assuring ourselves it is staying away from things it shouldn’t be doing.

I have already discussed one such thing to avoid, retreating from its commitments to finish the stories it delivers to fans. I won’t repeat those points just now, but there are a few other potential problems that bear watching. However, my bullish thesis remains intact for now.

Subscriber Projections

Market expectations generally match Netflix’s own forecast, for 3.2 million total net additions. That is being hailed as a “stellar” quarter by those who compare it to Netflix’s second quarter of 2016, when net adds dropped to below 2 million. However, as I noted at the time, that was caused by a thorough botching of the rollout of the un-grandfathering scheme by Netflix management.

This creates an artificially low base for investors as they compare Y/Y growth. In 2015, the second quarter saw the addition of 3.1 million net subscribers - almost exactly equal to the current projections. So while 3.2 million subscribers would be a fine result, I would caution investors not to get too caught up in the “stellar” rhetoric. 3.2 million would represent a return to normal patterns more than a breakthrough for Netflix, if that is all they add.

It is possible, however, that even these stellar estimates are too low. After it reported last quarter’s numbers, Wall Street analysts noticed something curious about Netflix’s subscriber guidance: in just 25% of the quarter, it had apparently achieved 40% of its subscriber growth, assuming Netflix hit 100m global subscribers that weekend as Hastings forecast.

While it is always possible that Netflix knows something about May and June that will cause fewer subscriber additions in that quarter, it is also possible that Netflix will post a substantial surprise to the upside today. Anything north of 4 million would have to be considered a more substantial beat, something worthy of a potential re-evaluation of Netflix’s growth trajectory.

Resist The Urge To Lash Out

As Netflix continues to approach the ceiling of its potential for US subscribers, there has been increasing calls from certain quarter for Netflix to crack down on the practice of account-sharing. They have been prompted by a new poll revealing the extent of account-sharing behavior, and some have gone so far as to also question whether Netflix’s free trials need revising, since they see that as just another doorway for people to get Netflix content without paying for it.

I just have to say this: the extent of account-sharing behavior is not news to most of us, despite the attempt by those who are late to wake up to its significance to paint it as such. Nor does the attempt to tie account-sharing and free trials together as some sort of cheating epidemic hold water. Any sort of crackdown would be ill-advised, and would do more to harm the Netflix brand and value proposition than it would to help the bottom line.

It would also be legally and practically impractical to implement. The legal jargon is that accounts are sold to “the household,” and can only be used by people belonging to “the household.” But the whole point of mobile video services is to take them outside the home, which makes policing account sharing all but impossible since “the household” really loses all meaning at that point. The household is whoever the account holder decides to give the password to.

Think Of Streams, Not Accounts

Netflix has repeatedly said it doesn’t mind account sharers, and most other services take a similar view. Really, there is no other view for them to realistically take. What’s more, Netflix has already taken the most reasonable and practical step to limit the damage of account-sharing: imposing limits on how many simultaneous streams each account can have. As I have been arguing for some time, the streaming video market today is about selling streams, not accounts. When Netflix sells a monthly subscription for $10, it is really selling two stream for $5 each.

If there is an economic shortfall in Netflix’s potential future earnings, the way to address it is to manage the price per stream directly, by either raising prices further or reducing the number of simultaneous streams per account. To try to put the digital and mobile genies back in the bottle and re-create the old analog “household” restrictions will be an administrative nightmare with little payoff.

Free Trials Are Good Money

The criticism of free trials is also off base. It’s true that for Netflix and other streaming services, only about one in three free trial users will graduate to paying customers. However, the same survey also found that the remaining two-thirds are composed overwhelmingly of legitimate customers who don’t like the service enough to pay for it, and leave. Serial free trial cheaters who fabricate new emails and perpetually obtain free service are overwhelmingly the exception, not the rule.

The marginal cost of delivering video service to a customer is very small - hands down, streaming video’s biggest cost is content - and losing the subscriber growth that free trials generates would almost certainly do far more damage than roping a few cheaters into the paying category would help.

Investment Implications

While I doubt very much management’s position on account-sharing or free trials has changed, it still bears watching during the earnings call following the results. In the unlikely event that management does indicate it is preparing or even considering some sort of crackdown, the significance of that should not be underestimated by investors. It would be a serious mistake and a considerable threat to my bullish position on Netflix. The convenience of mobile viewing without geographic restrictions, and without having to “prove” their household status, is one of Netflix’s best selling points.

Failing that, I see Netflix as remaining a strong buy and hold candidate, although the pace of advance is certain to slow from the nearly 100% gain we have seen over the past year. Evercore’s Rich Ross has been seeing technical signs of a breakout upwards, perhaps as high as $180. This isn’t his first bullish Netflix call: he made a similar prediction based on similar technical factors late last year, and he was proven right as the stock advanced to $160.

But it has been more or less treading water there for the past two months. A significant subscriber beat would likely send it upwards considerably, although it is not clear if Netflix can deliver a real beat since, as I said, 3 million is more or less par for the course despite last year’s deviation. Even so, Ross’s $180 price target seems a fair one to me. A real beat remains a possibility, and even without one Netflix is poised to at the very least maintain steady growth and continue to grow operating income and margins.

Price Is Not Unreasonable

Netflix’s high ratios remain a matter of some concern, but they are outweighed in this case by the fact that management appears to be executing well on a plan to deliver strong profit growth that will drive those ratios down over time. At 212, Netflix’s P/E is obviously high, but profits are being held down by the costs of international expansion and original content production. The benefit of low profit margins is that in absolute terms, they don’t have to grow so much to grow into a valuation. At only $186 million of profit in 2016, on over $8.8 billion of revenue, Netflix is currently sporting a roughly 2% profit margin.

If Netflix can grow to 200 million subscribers - I consider that a conservative estimate, since the company is over 100 million already and most international growth is still to come - with proportionate growth in revenue to $17.6 billion, costs would be unlikely to grow so fast since the content creation business is one with a certain inherent amount of leverage. Content creation is a fixed cost which becomes increasingly profitable when spread over a larger customer base. Time Warner (TWX), another company with a strong streaming platform - HBO - and content creation pipeline, sports a profit margin of over 13%. If profit margin grows to 10% for Netflix, the P/E ratio would fall to 21.

Given the potential for further growth and Netflix’s commanding position in the field of 21st century TV, that is not an unreasonable number.

Conclusion

Netflix remains on course to hold a strong position in Internet TV, continue to add subscribers, post stronger operating and net income margins, and deliver on the growth it needs to justify its share price. Most of the things that can go wrong at this point would be self-inflicted wounds, rather than those delivered by competitors. It is always a little nerve-wracking to be invested in a stock priced to such a high multiple. And there have definitely been some decisions by management I’ve disagreed with. Generally, however, management seems to recognize the danger, avoiding mistakes where possible and moving quickly to correct them when its not. I maintain my bullish thesis on Netflix.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Tagged: , Music & Video Stores, Earnings
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