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Netflix, Inc. Earnings: Domestic Growth Grinds to a Halt

By Adam Levine-Weinberg – Jul 18, 2016 at 7:45PM

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Netflix faced an unexpected increase in customer cancellations last quarter, causing a dramatic slowdown in growth -- especially in the U.S.

In the past few months, a growing chorus of Wall Street analysts have warned that Netflix (NFLX -2.04%) is starting to saturate the domestic market. The streaming video pioneer's Q2 results gave plenty of ammunition to analysts holding that viewpoint.

Netflix's growth slowed to a crawl during Q2. Image source: The Motley Fool.

On the other hand, while Netflix's subscriber growth fell short of expectations, the company performed well on every other key metric. Furthermore, the recent slowdown in subscriber growth doesn't necessarily represent the beginning of a long-term trend.

Growth slows dramatically

The big surprise in Netflix's quarterly report was the extent to which subscriber growth slowed. In the U.S., Netflix barely grew at all, adding just 0.16 million net subscribers. International growth was also substantially lower than it has been recently, with only 1.52 million net subscriber additions.

Thus, Netflix grew its global subscriber count by just 1.68 million during the second quarter. That's the slowest growth it has reported for any quarter since 2013. Here's a full rundown of the company's key business metrics in Q2 and how they compared to the forecast Netflix gave three months ago.

Netflix key Q2 metrics

Metric

April Forecast

Q2 Actual

Global streaming revenue

$1.96 billion

$1.97 billion

Operating income

$47 million

$70 million

Domestic subscriber adds

0.50 million

0.16 million

Domestic contribution profit

$403 million

$414 million

International subscriber adds

2.00 million

1.52 million

International contribution profit

($80 million)

($69 million)

Data source: Netflix Q1 2016 and Q2 2016 subscriber letters. Chart by author.

According to Netflix's management, gross subscriber additions were in line with the company's forecast. However, the news that Netflix would "un-grandfather" longtime customers who haven't been paying the current monthly subscription price drove a substantial uptick in cancellations, both within the U.S. and abroad.

What's interesting about this is that subscribers who were actually un-grandfathered during the quarter didn't cancel at a very high rate. But many people who didn't face a price increase during the quarter did cancel their service. Netflix executives suspect that these customers were misled by blaring -- and not quite accurate -- headlines such as "Your monthly Netflix bill is about to go up" that made them think Netflix had raised its prices again.

All is still well

Even though domestic subscriber growth came crashing to a halt in Q2, the company's domestic contribution profit came in comfortably ahead of the company's guidance. Netflix's international contribution loss was also lower than expected. In fact, the international contribution loss improved dramatically on a sequential basis, from $104 million in Q1 to $69 million in Q2.

The net result was that operating income reached $70 million, roughly 50% ahead of guidance and down just $5 million year over year despite Netflix's heavy investments in international expansion.

This shows that Netflix should be able to achieve substantial earnings growth in the future even if subscriber growth falls short of the torrid pace of 2015 and early 2016. Netflix also provided the most detailed proof yet that its international efforts are succeeding. For the full year, it expects to earn an aggregate contribution profit of $500 million in the international markets launched before 2014.

Looking ahead

Netflix expects growth to remain slow during Q3, with only 2 million global net subscriber additions. This is due to the ongoing impact of an elevated cancellation rate, as well as the expected negative effect of the Olympics on new sign-ups during August. Netflix also plans to ramp up its investment in international markets again during Q3.

Not surprisingly, Netflix investors reacted poorly to this earnings report. Netflix stock fell as much as 16% in after-hours trading on Monday.

Nevertheless, Netflix remains on track for strong earnings growth in the years ahead as it reaps the benefit of steady growth and margin expansion in the U.S. along with the maturation of its newer international markets. Long-term investors may want to seize this opportunity to pick up Netflix shares at last year's prices -- especially if the stock falls further in the near future.

Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Netflix. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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