On April 16, Netflix Inc. (NFLX, Financial) reported earnings for the first quarter of 2019. While its subscriber base continued to grow, things have slowed in the U.S., the streaming service’s home market. With a market capitalization of about $167 billion, Netflix clearly has massive future growth and profitability baked into its share price.
That enthusiasm looks increasingly misplaced. Indeed, the economics of Netflix simply fail to make much sense.
A strong first quarter
Overall, the first quarter was good for Netflix. Subscriber growth accelerated sequentially, with 9.6 million additions globally, compared to 8.8 million in the fourth quarter of 2018. This user growth exceeded expectations, with 1.74 million domestic and 7.86 million international additions, beating the Wall Street analyst consensus of 1.38 million domestic and 6.52 million international.
Netflix reported $4.52 billion in revenue, a 22.2% increase year-over-year, beating estimates by $20 million. Operating margin also improved, rising from 5.2% to 10.2%, resulting in free cash flow of $460 million for the quarter.
Earnings also impressed, with adjusted Ebitda of $538 million topping the expectations of $492 million. The company reported GAAP earnings per share of 76 cents, substantially better than the expected GAAP earnings per share of 57 cents.
But weakening guidance
Despite its solid first-quarter earnings, Netflix experienced a selloff in the immediate wake of its release. The cause of this initial slide was concern over weakened forward guidance. The company cut user growth guidance by nearly 10%, projecting 5 million additions in the second quarter instead of 5.4 million.
User growth expectations were not the only thing to take a hit. Netflix also expects its free cash flow deficit to expand in 2019. Due to tax changes, as well as investments in infrastructure and real estate, the company now anticipates cash outflow of approximately $3.5 billion.
At the same time, operating margin will likely be compressed going forward. The first-quarter improvement was due, upon closer inspection, to moving certain expenses further out in the year.
Putting the right spin on it
Despite the initial selloff, the market responded positively to the upbeat tone CEO Reed Hastings struck during the post-release earnings call. Hope still lies in the promise that, despite the persistent losses, Netflix is on the cusp of turning the corner for good:
“We’re still expecting free cash flow to improve in 2020 and each year thereafter, driven by our growing member base, revenues, and operating margins.”
This is certainly good spin, but it is difficult to grasp how trimmed guidance can truly be viewed as a bullish event. Evidently, Hastings’ confidence in Netflix’s growth story was catching, since the stock is now up more than 7% since the report.
Belief in the business model clearly persists, but can it last forever?
A problem of pricing power
Netflix’s investors have proven extremely patient. They have been willing to support an eye-watering valuation even as the losses have continued to mount. But Netflix has yet to prove that its business model is sustainable, let alone the profit-machine its valuation implies it will be.
The real key to financial viability boils down to pricing power. This is the test that will ultimately determine whether Netflix sinks or swims without constant infusions of external capital. Netflix has gradually increased its prices in recent months, with more hikes planned for the near future. Yet, with new and formidable opponents already rising to challenge its streaming dominance, the extent of Netflix’s long-term pricing power is rightly in doubt.
Verdict
Given Netflix’s current heavy cash burn and growth trajectory, we see little prospect of the long-promised profits materializing anytime soon. Indeed, it is likely that Netflix will have to weather a significant downward revaluation in light of more realistic growth prospects.
When that might happen is an open question, which makes a short-term short play look dangerous. However, long-dated put options might offer investors the necessary breathing room to outlast the growth narrative.
In the battle between dreams and reality, reality always wins. But it can take time for everyone to wake up.
Disclosure: No positions.
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