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Morningstar | Netflix Posts Strong Subscriber Growth to End 2018; Margin Expansion Remains Slow. See Updated Analyst Note from 17 Jan 2019

Netflix ended 2018 with stronger-than-expected international subscriber growth as the firm continues to benefit from its global expansion. Operating margin came in below our projections, however, as the firm pushed out some of its third quarter content and marketing spend into the fourth quarter. The free cash flow loss for the quarter was a record $1.3 billion, raising the loss for the year to just over $3 billion (19% of total revenue), a figure the firm expects to roughly match in 2019.

We are retaining our narrow moat rating and are raising our fair value estimate to $135 from $120, primarily from incorporating faster international customer growth. We believe the increased U.S. pricing, announced prior to earnings, will be largely offset by lower U.S. net customer additions in the near term and smaller subsequent price increases than the firm would have been able to implement had it taken a lesser increase this year. We also expect that the firm will face stronger competition in the U.S. and internationally, necessitating continuing increases in content and marketing spending which will result in continued cash burn and limited margin expansion over the next three years. In short, we don’t believe Netflix’s current share price considers the potential changes to consumer behavior that a combination of higher prices and increased competition could create, to the detriment of Netflix’s business.

Revenue of $4.2 billion came in line with our estimate. Netflix posted stronger-than-expected subscriber growth in the international segment (7.3 million net adds versus guidance of 6.1 million) but in line growth in the U.S. (1.5 million net adds, versus guidance of 1.5 million). Netflix continues to expand its streaming base, ending the quarter with more than 139 million global paid subscribers, up from 111 million a year ago.

Domestic streaming revenue of $2.0 billion was in line with our estimate and monthly revenue per paid U.S. member came in at $11.53, up 11% year over year and 1% sequentially. For international streaming, revenue of $2.1 billion matched our estimate as monthly revenue per paid member came in at $9.10, down 3% year over year and down 2% sequentially without foreign exchange adjustments. We expect the average revenue for the international segment to slowly decline as the firm adds more subscribers from emerging markets in which the firm charges under $9 per month. The segment contribution margin of 17.3% fell by 480 basis points year over year, leading to an operating margin of 5.2 % which was well below our 7.0% expectation.

Management continues to project that 2019 free cash flow loss will be roughly in line with the 2018 loss of $3 billion. 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, WarnerMedia, and NBCUniversal all plan to launch their respective SVOD services in late 2019 and 2020. These firms could be joined by Apple. As we noted in our recent ad-hoc report, "Netflix Need to Chill: The Director‘s Cut," 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.

We also believe that the firm will need to further deepen its own library as these companies start pulling their content off Netflix completely or offering it concurrently on other platforms. While management claims that most of the top 25 viewed shows by season are original content, the recent deal to retain Friends for a reported $100 million for one additional year demonstrates the importance of third-party content to Netflix viewers. We also note third-party viewing statistics imply that the 10 most watched shows as a percentage of total views are licensed by Netflix with eight of the shows owned by Disney/Fox, NBCU, Warner Bros, or CBS. While some of these firms will continue to license shows to Netflix, all four either have or expect to launch a SVOD platform in the next 18 months. Some of these shows such as Friends, The Office, and Grey’s Anatomy have completed multiple broadcast television seasons, and each have over 200 episodes (Grey’s has over 350) for viewers to watch and rewatch. In contrast, two of the longest running Netflix original series, House of Cards and Orange is the New Black, will end with only 73 and 91 episodes, respectively.

When any of these third-party shows are pulled, Netflix will need to ramp up its investment to add many hours of additional content to satisfy viewers. These viewers will soon have even more options to choose from when selecting an SVOD platform or platforms. Despite management’s hubris about competing more with Fortnite than Disney+, we think that the fragmentation within the SVOD marketplace will impact Netflix and its ability to hold its subscribers more than the overarching media fragmentation which is simply part of overall landscape for all media firms.