Image source: Netflix.
After the closing bell on Monday, Netflix (NFLX 0.75%) reported results for the third quarter of fiscal year 2016. In after-hours trading action, share prices rose as much as 21.5% on the news.
Here's a closer look at Netflix's third quarter.
Netflix Q3 results: The raw numbers
| Metric |
Q3 2016 Actuals |
Q3 2015 Actuals |
Growth (YOY) |
|---|---|---|---|
|
Revenue |
$2.29 billion |
$1.74 billion |
32% |
|
GAAP net income |
$51.5 million |
$29.4 million |
75% |
|
GAAP EPS |
$0.12 |
$0.07 |
71% |
|
Net domestic streaming members |
47.5 million |
43.2 million |
10% |
|
Net international streaming members |
39.3 million |
26.0 million |
51% |
Data source: Netflix (link opens PDF). YOY = year over year.
What happened with Netflix this quarter?
The digital video veteran exceeded its own estimates for several key metrics.
- Management had expected to add just 300,000 new members in the domestic market and 2 million for the international segment. Instead, Netflix landed 370,000 net new domestic subscribers and 3.2 million new overseas accounts.
- The process of ending grandfathered pricing policies is now 75% complete, boosting both domestic and international sales per subscriber by more than 10% year over year.
- Revenue and earnings may be on the rise, but Netflix also burned a lot of cash this quarter. Free cash flow came in at negative $506 million, about twice the size of the second quarter's cash losses. The company is spending lots of cash on content production, and plans to increase those expenses in future reporting periods.
For the fourth quarter, Netflix's management offered the following guidance figures:
- Domestic subscriber additions should stop at 1.45 million new accounts, roughly comparable to the 1.56 million additions seen in the year-ago quarter.
- International additions are expected to follow suit at 3.75 million net new subscribers, down from 4.04 million in the equivalent 2015 period.
- Global streaming revenue is seen rising 40% year over year, landing at $2.34 billion.
- Earnings per share could get a 30% boost to $0.13 per share.
What management had to say
In the earnings release, CEO Reed Hastings took the time to explain why those negative cash flows are growing so large:
The increase in our free cash flow deficit reflects the growth of original content, which we are increasingly producing and owning (rather than licensing). Self-produced shows like Stranger Things require more cash upfront as we incur spending during the creation of each show prior to its completion and release. In comparison, we generally pay on delivery for licensed originals like Orange Is the New Black and we pay over the term of the agreement for licensed non-originals (e.g., Scandal).Over the long run, we believe self-producing is less expensive (including cost of capital) than licensing a series or film, as we work directly with the creative community and eliminate additional overhead and fees. In addition, we own the underlying intellectual property, providing us with global rights and more business and creative control. Combined with the success of our portfolio of originals and the positive impact on our member and revenue growth, we believe this is a wise investment that creates long term value. Consequently, we plan on investing more, which will continue to weigh on free cash flow.
Hence, fourth-quarter cash flows will be about the same as the third quarter's reading. Larger jumps should come over the next few years, before the long-term value of the early cash investments should start to turn that negative trend around.
Looking ahead
Hastings is taking a step back from his ambitions to enter the Chinese market. Difficult regulatory conditions are changing Netflix's strategy in China. The company will continue to look for ways to enter the world's largest consumer market in a direct way, but will settle for selling content licenses to local video services in the meantime.
In 2017, Netflix plans to nearly double the amount of original programming it produces from 600 hours to 1,000 hours. That effort will weigh heavily on the cash flow statement, but the costs will balance out against depreciation and amortization items and thus make a much smaller impact on the income statement. Hastings characterized the current income levels as "near breakeven," but still sees his company "generating material global profits in 2017 and beyond, by marching up operating margins steadily for many years."
