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Ishan Majumdar
Ishan Majumdar
Articles (131)  | Author's Website |

Netflix: The Slow Production Activity Is Actually a Boon

The company delivered a tepid result but is flush with cash owing to the slower production activity in 2020

October 21, 2020 | About:

Netflix (NASDAQ:NFLX)'s results are one of the most eagerly anticipated events of the earnings season, not just for technology investors but for the market as a whole. The global streaming giant's performance acts as a barometer for the growth in the online streaming industry.

The recent results were below the sky-high market expectations. After a phenomenal start to the financial year backed by subscriber-growth-related tailwinds caused by the Covid-19 pandemic, Netflix's growth in the most recent quarter has come back to realistic levels, disappointing the market. However, the slow production activity during the year has resulted in the company having plenty of cash. In my view, this makes it set for a strong 2021.

Financial results and guidance

Netflix's results for the third quarter of 2020 were a disappointment as the company reported a below-par subscriber growth, resulting in lower-than-expected earnings.

The company reported revenue of $6.44 billion, a growth of 22.7% over the corresponding quarter of the previous year, which beat the analyst consensus estimate of $6.39 billion.

However, its profitability was not up to the mark, and there was a visible dip in the operating income, which fell to $1.315 billion from $1.358 billion in Q2 2020 resulting from the weakening average revenue per user (ARPU) in the Latin American and the Asia Pacific markets, including forex adjustments. The company's weak subscriber additions as compared to the preceding quarter also indicated the end of the Covid-19 tailwinds for the company.

Over and above the subscriber growth, Netflix managed to disappoint on the earnings front. The company reported earnings per share (EPS) of $1.74, which was way below the analyst consensus estimate of $2.13 and which sent the stock down.

With respect to guidance, the company's forecast of $6.57 billion in revenue for the next quarter is more or less on par with the analyst estimates, but it is evident that the analyst community has become more conservative about earnings forecasting. While the company is expecting EPS of $1.35 in the next quarter, analysts have lowered their expectations to 94 cents per share.

Subscriber growth

One of the biggest concerns for the shareholders of Netflix is with respect to the company's ability to be able to maintain its shareholder growth, especially with the pandemic lockdown tailwinds disappearing and the competition intensifying. Netflix disappointed the market by reporting hardly 2.2 million new subscribers, well below the 3.32 million number forecasted by analysts, as well as the company's own more conservative forecasts.

The company has heavily benefitted from the Covid-19 pandemic and started the financial year by adding 25.9 million subscribers in the first two quarters, which was the best first half of the year ever for the company. The management was expecting a slowdown post the lockdown ending as people have gone back to other activities instead of bingeing the content of the streaming giant. Sports activities resuming all over the world in the past quarter were also a big factor in the subscriptions slowing down.

Source: Netflix Shareholder Letter – Q3 2020

As we can see in the above extract, the drop in the additional memberships was uniform across geographies. The U.S.-Canada subscriber base continues to be the biggest contributor to Netflix's top-line, followed by the Europe, Middle East and Africa (EMEA) region.

The competition is intensifying for the company with players like Comcast's (NASDAQ:CMCSA) Peacock, Amazon (NASDAQ:AMZN) Prime and Disney's Disney+ (NYSE:DIS) gradually gaining market share in key markets. The management has explicitly warned investors to tone down their expectations with respect to subscriber growth in the coming quarters.

Surplus cash from slow program pipeline

Netflix's program pipeline has slowed down over the past few months with production activity coming to a near standstill as a result of the lockdown. The shutdown of movie theatres did create many short-term opportunities for the company to acquire films from studios and to continue putting up new content and attract subscribers. Some examples include names like The Old Guard, Project Power, The Kissing Booth 2 and many more. The purchased movies and content are known to perform better than originals, and these helped the company to continue attracting subscribers.

However, these are expected to die down with cinemas opening gradually all over the world. The good part is that the production activity is back on track for Netflix as well, and the management is addressing the relatively weak performance of its original series through the restructuring of its internal production divisions. In fact, they claim to have completed about 50 projects since the initial shutdown that are expected to release.

I think the slowdown in program production is actually beneficial for Netflix in a number of ways. It has resulted in lower production costs, implying lower cash outflows and indicating that Netflix could finally post a positive annual free cash flow for the first time in many years. This is definitely a positive update for a company that is reporting a positive bottom-line and yet is using up its cash reserves each year to aggressively fund its expansion and remain the largest streaming service. The $8 billion cash balance ensures that Netflix will have enough funds to support expansion as well as the production of new content in 2021 and is certainly a green flag for the shareholders.

Final thoughts

After its most recent result, many would say that Netflix has lost its ability to capitalize on the Covid-19 pandemic, and that would be true. However, it does not necessarily mean that the company's stock is expected to stop growing. Even after the recent fall, the stock has still appreciated 7% in the past three months. Netflix has a lot to look forward to in 2021 in terms of new content and penetration in international markets. Most importantly, it has sufficient cash to achieve its vision.

I think the recent decision of the management to gradually discontinue the free trial is another indicator of the strong confidence that they have in the offerings and the brand. Overall, I believe that there is no reason for investors to panic and they can comfortably hold on to the stock and enjoy decent returns for 2021.

Disclosure: No positions.

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About the author:

Ishan Majumdar
I am a qualified Chartered Accountant with a Masters in Management (Grande Ecole) from HEC Paris. I run a proprietary boutique financial advisory firm called Baptista Research (www.baptistaresearch.com) specializing in M&A, corporate advisory, equity research and valuation of listed companies.

I have nearly a decade of experience spread across investment banks, financial advisory firms, investment funds and other corporates in many different geographies, such as France, Spain, India and others. I was a part of the LBO Financing team at BNP Paribas where I worked on deals with a combined enterprise value of over $1 billion. I have also worked in mergers and acquisitions with Credit Agricole CIB and corporate strategy with Groupe Danone SA. Over the years, I have developed a strong specialization in corporate valuations, strategy and financial analysis.

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