Netflix (NASDAQ:NFLX) was expecting 5 million new paid subscriptions in the second quarter, but racked up only 2.7 million, including a loss of 126,000 U.S. subscribers. Netflix stock has fallen 21% since July 17 when it reported these numbers. But NFLX stock will survive this fall.
First of all, NFLX has consistently had really bad subscriber growth every Q2. This past quarter was no exception. NFLX explained the drop as a pull-forward effect from large Q1 additions. More importantly, it admitted that its content slate didn’t pull in subscribers as expected.
But here are some positives to not throw out lightly …
Netflix is now expecting 6.2 million net additions in Q3. This includes U.S. paid membership additions of 0.8 million, and the rest is expected to come from outside the U.S. All eyes will be on the Q3 numbers to see if these expectations are met.
Netflix Is Very Healthy Financially
Second, whatever happens with net additions, which the market seems to be obsessed with, Netflix’s financial health remains extremely strong. Contribution profit (essential gross profit after distribution costs) grew 19.5% sequentially in the U.S. to $852 million (with negative paid membership growth). Non-U.S. contribution profits grew 51.8% to $416.3 million.
Moreover, NFLX posted strong positive EBITDA growth in Q2. EBITDA is a cash flow measure that eliminates the huge content amortization charges that NFLX deducts from its net income before all interest and tax expenses. It helps investors and management understand how well the company can afford its financial leverage.
Adjusted EBITDA rose 43.1% in Q2 over Q1 to $836 million. This is a massive increase and augurs well for the company’s ability to eventually become free cash flow positive. Keep in mind that Netflix includes its net content slate expenditures in its adjusted EBITDA measure. These totaled a net $1.1 billion in Q3 after amortization. So clearly the company can keep on affording to pay for its higher content expenditures.
In effect, Netflix’s subscriber base is now so profitable on a cash flow basis that, as the company explained in its very well-written shareholder letter, free cash flow profits will eventually come as it builds its member base, revenues and operating margins.
This is the same thing that happened at Amazon (NASDAQ:AMZN). For many years AMZN produced strong EBITDA cash flow profits but had deficits in free cash flow. AMZN spent its pre-interest cash flow on investments and built up the attractiveness of its Prime subscriber base. This eventually led to huge free cash flow profits.
The same is happening at Netflix. NFLX’s content slate has to stay good enough to pull in new subscribers and also reduce churn related to other competitors’ new products. That will increase Netflix’s EBITDA cash flow even further. Just like it did in Q2. Netflix’s increasing content investments have a good chance of producing a large and loyal subscriber base that will generate positive free cash flow.
NFLX Stock Will Likely Recover
Analysts are beginning to re-assess NFLX stock after this latest downturn. RBC Capital, for example, reiterated its “outperform” rating on the stock after an internal survey on U.S. penetration and subscriber churn came in favorable. The RBC analyst also does not believe that the new Disney OTP offering is going to be a threat to Netflix over the next year and thereafter.
As the analyst pointed out in the interview on CNBC in the link above, Netflix is in a scale business. As it loses Disney content, NFLX will not only have more money to spend on its own content, but it will have so many subscribers, increasingly overseas, that its profits will scale up as well.
As for the free cash flow deficit issue, RBC points out that FCF is inherently an elective issue, not a structural problem. Just like at AMZN, Netflix can elect at any point to reduce its content spending to turn out free cash flow. Its huge EBITDA profits are indicative of this.
As a result, keep focusing on Netflix’s total subscriber growth, not just in the U.S. This inherently will lead to higher net income, EBITDA and free cash flow measures of its profitability. In turn, the NFLX stock will eventually move upward as the overall subscriber growth continues.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide which you can review here.