Feel the Netflix Burn

Yes, the company beat forecasts for users, but there's no guarantee they'll pay off.
At Closing, May 23th
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Netflix is a Rorschach test for investors. Do they look at the company's financials and see a sensible bet on a promising future or a disaster waiting to happen? 

For the second consecutive quarter, Netflix added fewer than half a million net new subscribers to its web-streaming service in the U.S. That was the worst stretch of net customer additions in five years. But the company signed up more customers than it had forecast in the third quarter, and it expects the new sign-ups to perk up in the fourth. Netflix's big bet on international expansion also appears to be going well, with a better-than-expected 3.2 million net new subscribers. 

The healthy subscriber gains support Netflix's contentions that it had hit a temporary hiccup in customer growth because of recent price changes that resulted in an effective price increase of $1 or $2 a month for many people. Netflix said it added more customers than it expected primarily because of "excitement around Netflix original content."

The company's stock price, which had hit a rough patch after a stellar 2015, soared about 19 percent in after-hours trading. 

Domestic Disturbance

Netflix hit a rough patch for net new U.S. subscribers, but it forecasts sign-ups will accelerate in the fourth quarter

Source: Bloomberg and Netflix

Note: Net new subscribers are fresh customer sign-ups minus existing subscribers who quit.

People who look at the Netflix ink blots and see sunny skies should be comforted by the latest quarterly results. But they also should remember that Netflix needs its U.S. business to perform perfectly to bankroll the company's global ambitions. And it's far from perfect.

The three months ended Sept. 30 were the eighth quarter out of the last 10 in which Netflix signed up fewer net new streaming U.S. subscribers than it did in the same quarter a year earlier. Even the expected jump in subscribers Netflix forecasts for the fourth quarter to 1.45 million would be fewer than the 1.6 million net new U.S. subscribers the company added in the final three months of 2015.

Netflix is also going deep into the red to expand its web streaming into nearly every country in the world and to pay for the TV shows and movies that will lure people and keep them hooked. The company hasn't posted positive free cash flow in two years, and free cash flow deteriorated to negative $489 million in the third quarter as the company spent more on those exciting original shows. Netflix is on the hook for $14.4 billion 1 in future payments for streaming video programming. That's nearly double the company's revenue for the last 12 months.

Cash Bonfire

Netflix's free cash flow has turned negative in the last two years as the company spends on new programming and international expansion

Source: Bloomberg

Of course it's fine for a company to spend cash to expand if it thinks the opportunity is worth the costs. Optimists about Netflix's plans to become the first global TV network say it absolutely is. But that's debatable. The question hinges on whether the rest of the world takes to Netflix as people did in the U.S., where the company saw the potential of web video early on, amassed 48 million customers and now has profit margins that look more like those for near-monopoly companies such as Comcast than those for other fast-growing but cash-burning tech companies like Square and FireEye. 

Netflix's U.S. contribution margin rose in the third quarter to 36.4 percent -- meaning for each dollar of revenue from its U.S. streaming business, Netflix has 36 cents left after paying for its programming, the costs of distributing the shows online and marketing to land new subscribers.

Based on the company's limited disclosures about countries where it launched before 2014, RBC estimates Netflix has a contribution margin of roughly 20 percent in those international markets -- similar to its U.S. margins in 2013. Getting anywhere close to that level outside the U.S. would bring huge profits raining on Netflix. 2 The company on Monday reiterated that it expects to generate "material global profits in 2017 and beyond." 

But Canada, Finland and the U.K. -- where Netflix arrived before 2014 -- may not have the same dynamics as Indonesia, Spain, India and other countries with huge populations but an untested willingness to pay for Netflix. In a potential illustration of Netflix's challenge, HBO’s online subscription service draws 10 cents for each subscriber in Vietnam but $10 for each one in Scandinavia, Bloomberg’s Gerry Smith reported earlier this year.

Netflix has made fools of its doubters many times before. And Monday's healthy subscriber growth erased some of the fresh doubts about a Netflix subscriber growth black hole. Yet a shiny coat of paint can't hide the structural damage in the house of Netflix.

(Corrects figure for contribution margin in the ninth paragraph.)
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
  1. Those are its balance-sheet liabilities for programming costs. Netflix also has off-balance-sheet liabilities. 

  2. Currently, Netflix's international streaming business has a total contribution margin of negative 8 percent, which is an improvement. 

To contact the author of this story:
Shira Ovide in New York at sovide@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net

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