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Netflix (NFLX): The Rally Is On!


Netflix (NASDAQ:NFLX) stock catapulted 7 percent higher in after-hours trading Monday after a blowout first-quarter earnings report that showed more subscriber additions than Wall Street expected.

Let’s take a closer look at the video streaming giant’s Q4 letter to shareholders:

Q1 Results and Q2 Forecast

Revenue grew 43% year over year in Q1, the fastest pace in the history of our streaming business, due to a 25% increase in average paid streaming memberships and a 14% rise in ASP. Operating margin of 12% rose 232 bps year over year. This was higher than our beginning of quarter guidance, due primarily to the timing of content spend. Diluted EPS of $0.64 vs. $0.40 included a $41m non-cash unrealized loss from F/X remeasurement on our Eurobond.

Global net adds totaled a new Q1-record of 7.41m, up 50% year over year and ahead of our 6.35m forecast. The variance relative to our guidance was driven by continued strong acquisition trends across the globe which we attribute to the growing breadth of our content and the worldwide adoption of internet entertainment.

In the US, we added 1.96m memberships (compared with forecast of 1.45m). We completed our price adjustment during this past quarter, resulting in 12% ASP growth for the domestic segment. Outside of the US, membership grew by 5.46m (vs. forecast of 4.90m). Our international segment now accounts for 50% of revenue and 55% of memberships. Excluding a F/X impact of +$114 million, international revenue and ASP rose 59% and 13% year over year, respectively.

As a reminder, the quarterly guidance we provide is our internal forecast at the time we report. For Q2, we expect 6.2 million global net additions (1.2m in the US and 5.0m for the international segment) vs. 5.2 million in the year ago quarter. Q2 operating margin is expected to be 12%. We are now targeting a full year operating margin of 10%-11%. We continue to anticipate content and marketing spend to be weighted towards the second half of 2018.

Content

We’ll have $7.5-$8 billion of content expense (on a P&L basis) in 2018 across a wide variety of formats
(series, films, unscripted, docs, comedy specials, non-English language) to serve the diverse tastes of our
growing global membership base.

Q1 scripted original series debuts included the dark, coming of age story The End of the F***ing World
and sci-fi thriller Altered Carbon as well as returning seasons of Marvel’s Jessica Jones, Grace and
Frankie, Santa Clarita Diet and A Series of Unfortunate Events.

Last year, we expanded our efforts in original programming to unscripted shows across several genres.
Our output in this area is now comparable to similarly-focused US domestic cable networks. Shows like
Queer Eye and Nailed It are great examples of our ambitions in this area: engaging, buzz-worthy shows
that drive lots of enjoyment around the world.

Our investment in international production continued to increase with big, non-English originals like O Mecanismo (The Mechanism). Loosely inspired by real events and from Narcos creator José Padilha, this drama is tracking to be one of our most viewed originals in Brazil. We are also seeing more examples of non-English content transcending borders. This quarter, La Casa de Papel (Money Heist in English anguage territories), a Spanish language heist thriller, became the most watched non-English series on Netflix ever.

On Super Bowl Sunday, we surprise-announced and launched The Cloverfield Paradox, the third film in the Cloverfield franchise. Through tight coordination among our original film, product, marketing and PR teams, the event showcased how a big branded film can be marketed and delivered to consumers instantaneously across the globe without a wait for the theatrical window. Outside of North America, we premiered the Alex Garland-directed Annihilation, starring Natalie Portman, just weeks after its US theatrical debut and it has enjoyed large audiences in nearly every country for us. We also released a broad range of original films: from Benji for kids and families; to the Seth Rogen/Evan Goldberg produced comedy Game Over, Man; to the Sundance hip-hop biopic Roxanne, Roxanne.

We regret our films not being able to compete at this year’s Cannes film festival. The festival adopted a new rule that means if a film is in competition at Cannes, it can not be watched on Netflix in France for the following three years . We would never want to do that to our French members. We will continue to 1 celebrate our films and filmmakers at other festivals around the world but unfortunately we will have to sit out Cannes for now so that our growing French membership can continue to enjoy our original films.

This past quarter, we signed an overall deal with Ryan Murphy, the prolific hit-maker behind American Crime Story: The People vs. OJ Simpson, Nip/Tuck, Glee, American Horror Story and many others. This comes on the heels of similar partnerships with Shonda Rhimes, Shawn Levy and Jenji Kohan. While these overall deals are a substantial investment for us, they allow us to work directly with prolific and talented creators with a proven track record of success. Instead of having to license their shows for a finite period from outside suppliers, we will own the projects we produce with them. This approach also allows us to reduce our reliance on third-party studios and forego the corresponding license premiums we’ve historically paid.

We were proud to celebrate our first feature Academy Award with Bryan Fogel and Dan Cogan, makers of our documentary Icarus. We’re thrilled when the creators with whom we partner are recognized for their exceptional work. The Oscar win helps to reinforce that Netflix is a great home for both documentary lovers and creators.

Marketing

We’re investing in more marketing of new original titles to create more density of viewing and conversation around each title (i.e bigger hit in a nation or demographic). We believe this density of viewing helps on both retention and acquisition, because it makes our original titles even less substitutable. Because we operate in so many countries, we are able to try different approaches in different markets, and continue to learn.

Product and Partnerships

Last year, we launched bundle offers with Proximus (in Belgium), SFR Altice (France) and T-Mobile (US). They have proven to be very successful and we are now adding similar bundle offers with additional MVPD partners. Recently, we announced that we are bundling the Netflix service with packages from Sky which will begin later this year and with Comcast in the US, which are currently being rolled out. These relationships allow our partners to attract more customers and to upsell existing subscribers to higher ARPU packages, while we benefit from more reach, awareness and often, less friction in the signup and payment process. We believe that the lower churn in these bundles offsets the lower Netflix ASP. We remain primarily a direct-to-consumer business, but we see our bundling initiative as an attractive supplemental channel.

In March, we rolled out additional features providing members with greater information and control over their Netflix viewing. While we had already offered PIN protection for all content at a certain maturity level, there is now a parental PIN control for individual movies and shows. These new features are part of our ongoing effort to give our members tools to manage how they and their families enjoy Netflix.

Free Cash Flow and Capital Structure

Free cash flow in Q1 was -$287 million (less negative than we expected due to content payment timing differences), compared with -$524 million in Q4’17. We continue to forecast free cash flow of -$3 to -$4 billion in 2018, and to be free cash flow negative for several more years as our original content spend rapidly grows.

We have about $2.6 billion in cash and we will continue to raise debt as needed to fund our increase in original content. Our debt levels are quite modest as a percentage of our enterprise value, and we believe the debt is lower cost of capital compared to equity.

Analyst Ratings

The word on the Street rings largely bullish on this streaming giant, with TipRanks analytics demonstrating NFLX as a Buy. Out of 36 analysts polled in the last 3 months, 22 are bullish on Netflix stock, 13 remain sidelined, while only 1 (Wedbush’s Michael Pachter) is bearish on the stock.