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Morningstar | Netflix Misses Badly on Subscribers; 3Q Guidance Appears Conservative

Netflix posted much weaker-than-expected subscriber growth in second quarter of 2018 as the firm missed its total streaming add guidance by one million subscribers. We believe the miss induced management to issue conservative third-quarter subguidance that came in below consensus expectations. While segment contribution margin came in above our projections, the firm pushed out its content and marketing spend into the second half of the year. As a result, the free cash flow loss for the first half was $846 million, an improvement sequentially from the loss of $989 million in the second half of 2017. However, management reiterated its projection for free cash flow burn of $3 billion to $4 billion for 2018. This guidance implies a free cash flow loss of $2.2 to $3.2 billion in the second half which would be larger than the $2 billion burned over all of 2017. We are retaining our narrow moat rating and our fair value estimate of $90 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.

Netflix reported worse-than-expected subscriber growth in both the international (4.47 million net adds versus guidance of 5.00 million) and U.S. segments (0.67 million net adds, versus guidance of 1.20 million). Management could not explain the miss and instead pointed out their poor record of projecting net adds over the last two and half years. Netflix continues to expand its streaming base, ending the quarter with more than 124.35 million global paid subscribers, up from 99.04 million a year ago. Revenue of $3.91 billion came in line with our $3.92 billion estimate. Domestic streaming monthly revenue per paid member came in at $11.37, up 13% year over year and ahead of our $11.25 estimate. For international streaming, revenue of $1.92 billion was slightly below our $1.95 billion estimate as monthly revenue per paid member came in at $9.69, up 17% year over year.

While the segment contribution margin of 27.9% outperformed our projection by 93 basis points, operating margin of 11.8% 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. Part of the increased spend for the firm is build out of its own studio. 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.

One market that competitors are underpricing Netflix in is India, a market that management has pointed as a potential driver of subscriber growth longer term. Unlike China where Netflix is locked out, Netflix is on the ground in India and attempting to drive growth by investing in original content. However, both Amazon and Fox's Hotstar are both priced well below Netflix which is charging roughly $7 to $12 per month. In contrast, Amazon offers its Prime service including the SVOD offering for $2 per month and Hotstar has a very popular free tier that is ad-supported. As a result, Netflix is currently in third place in terms of paid subs and has limited its reach to a subsection of the growing Indian middle class due to its high price. We believe that India will be a challenging market for the firm given the competition which will be strengthened when Hotstar is sold to either Disney or Comcast as part of the Fox assets sale.