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Morningstar | Netflix Beat Its Conservative Guidance; Free Cash Burn Expected to Remain Elevated in 2019

Netflix reported stronger-than-expected subscriber growth in third quarter of 2018 as the firm beat its very conservative total streaming add guidance by two million subscribers. Segment contribution margin came in above our projections as the firm pushed out some of its content and marketing spend into the fourth quarter. Despite the shift, the free cash flow loss for the quarter was $859 million, raising the loss for the year to $1.705. We are retaining our narrow moat rating and our fair value estimate of $120 as we project that the firm faces increased competition over the next five years, necessitating an ongoing cash burn and curtailing the speed of margin expansion.

Revenue of $4.00 billion came in line with our $4.06 billion estimate. Netflix posted stronger-than-expected subscriber growth in both the international (6.07 million net adds versus guidance of 4.45 million) and U.S. segments (1.00 million net adds, versus guidance of 0.70 million). Netflix continues to expand its streaming base, ending the quarter with more than 130.42 million global paid subscribers, up from 104.02 million a year ago.

Domestic streaming monthly revenue per paid member came in at $11.44, up 13% year over year and flat sequentially. For international streaming, revenue of $1.97 billion was slightly below our $2.04 billion estimate as monthly revenue per paid member came in at $9.27, up 6% year over year but down 4% sequentially. While the segment contribution margin of 28.8% outperformed our projection by 232 basis points, operating margin of 12.0% came in much tighter to our 11.7% expectation. The firm continues to ramp its R&D and G&A spend, limiting leverage of these categories.

Netflix purchased a production lot in Albuquerque, New Mexico which will serve as a new hub for U.S. content production. The firm also continues to spend on technology development, particularly on the mobile side. While the mobile opportunity could be large in a market, we believe that the firm’s premium pricing will limit the uptake, particularly if competitors continue to undercut Netflix on price.

Management now projects that free cash flow burn will come in toward the bottom end of its original projections of a loss of $3 billion to $4 billion for 2018. This guidance implies a free cash flow loss of over $1.3 billion in the fourth quarter which would be by far the largest single quarter loss for the firm. Netflix also provided updated guidance for 2019 free cash flow loss to be roughly in line with the expected 2018 loss. Previously, management had guided that the loss would be slightly lower in 2019. While management expects 2020 to be an "inflection point" for the cash burn, we expect stronger competition in 2020 and beyond for the firm as Disney launches its announced SVOD service which could be joined by offerings from WarnerMedia, Walmart, and even Apple. These launches imply that Netflix may need to keep its content spend elevated to stave off competition from companies with deep libraries and/or multiple sources of revenue.