If you wanted to pick a pair of contrasting images from the tech sector, you could hardly do better than the quarterly reports delivered this week by Netflix (NFLX 1.91%) and IBM (IBM 0.71%). The streaming-video company is one of the business world's biggest winners when it comes to capitalizing on trends like high-speed internet and big data, and its latest outperformance shows that it has yet to plateau. IBM, by contrast, is an aging pioneer trying to pivot into a position from which its new "strategic initiatives" segments can deliver sufficient growth to compensate for the shrinkage in its legacy businesses -- and while it finally managed that for a few quarters recently, its brief growth streak just ended.
In this Market Foolery podcast, host Chris Hill and senior analyst Andy Cross discuss the two earnings reports and the broader situations at both companies and also answer a question from a listener who wants to know where he should look to get a better idea of what the companies he's considering investing in view as strategically key.
A full transcript follows the video.
This video was recorded on Oct. 17, 2018.
Chris Hill: It's Wednesday, October 17th. Welcome to Market Foolery! I'm Chris Hill. Joining me in studio today, the one and only Andy Cross. Thanks for being here!
Andy Cross: Chris, it's a pleasure! Happy Cannabis Canada Day!
Hill: Yes. To our friends to the north.
Cross: Up north.
Hill: One of our listeners in Canada sent me an email. He took a photo of the front page of the Toronto Globe and Mail newspaper. The banner headline was Day One, and a marijuana leaf.
Cross: Exciting times up there with the legalization of recreational cannabis.
Hill: It'll be very interesting to see what happens with all that. We're going to dip into the Fool mailbag. We're going to take a look at Big Blue. We're going to start with Netflix, though. Third quarter report for Netflix, forget the revenue, forget the profits. It's all about the subscribers. They crushed this number, adding just under seven million new subscribers.
Cross: It was a great quarter for Netflix. On pretty much every metric they give guidance on, they beat, and they have a lot of transparency in their numbers. It was extensive. Like you said, seven million net subscribers vs. five million expected. They added more than one million net additions of subscribers on the U.S. side and almost six million on the international side. Remember, it was just three months ago when investors were really concerned that the growth of Netflix had started to tailor off a little bit. They came up a little bit short on the subscriber line. Clearly, this quarter, they knocked it out of the park. Streaming revenues were up 36%. Average paid membership numbers were up 25%, and that paid membership one is what they really are now going to focus on. The average selling price is up 8%. Overall, a really impressive quarter by the streaming content leader of the world.
Hill: The stock is up today. Yes, it's down from the highs of a few months ago, but year to date, it's up 80%. I mean, is it expensive? Someone like me, who is not a shareholder and has never been a shareholder, I look at that and I have to be honest, my gut instinct is, "Well, I can't buy it now!"
Cross: I added some to it earlier this year, when the stock got knocked around after the last quarter, when the stock had fallen 10-15%. When you think about this business, it's $150 billion market cap. In the global media landscape that they are playing in and competing in, and the success they are seeing, I think with the leadership team of Reed Hastings, who owns about 1.5% of the business, they have extensive growth opportunities around the globe. Clearly, the U.S. is the slower-growing market. International is really where they're focusing on. They're spending $8-12 billion per year on content that they are developing. So much of that is turning into in-house content development. They have hundreds and hundreds of original programs now. They're going to spend up to $1 billion on an Albuquerque, New Mexico production studio for the next 10 years, where they're going to develop a lot of their individual content. Clearly, they are becoming a content and distribution king around the world. They're starting to focus more and more on these individual markets around the world. It's not just U.S.
I look at that and I say, you know what? For 1–2% of your portfolio, I think Netflix is well worth the addition in there.
Hill: Jim Mueller was in the studio recently, and we talked about that acquisition of the studios in New Mexico. Just like you, he brought up their expansion, particularly in Europe. I think they have some recent new studios in Spain. It's really going above and beyond what I think some people had expected, in terms of, not just their global expansion. They've proven that they can get subscribers around the world. But it's the production side of things, and their ability, now, with a network of studios in the United States and out that, they're able to go to film producers, show runners, etc., and say, "Wait a minute. If you're looking to go overseas, talk to us, because we've got some options for you."
Cross: And that's really important, because over in the European Union, there are regulatory changes in play. Eventually, at least 30% of the content of your library for a streaming service will have to be European-focused and European-produced. They are going into those markets.
It's also having an impact on what's happening competitively. We saw Comcast (CMCSA 2.38%) go after Sky aggressively and spend a lot of money for Sky, up to $40 billion to be able to get that distribution platform. When I add it all together, yes, the lack of free cash flow has been a concern as they continue to spend more and more money.
We did see, this quarter, their operating profit picture improve. A lot of that was some timing. They have a lot of flexibility when it comes to how to manage these costs. They've been doing that quite well. They talked about that. They have some nice expectation for profitability next year. Their cash burn for next year, they think, will be flat to this year. It's not going to worsen. That's good news for shareholders. They're going to continue to invest in these platforms. I think they will be able to continue to grow their subscriber base at a rapid clip, and certainly more rapid than some of the established players in there. That's all good news for shareholders.
Hill: It's interesting to hear about the cash burn. Ahead of this earnings report, we saw analysts at places like Morgan Stanley and Goldman Sachs essentially cut their price target on Netflix in part because of, yes, rising interest rates, but also perceived increased expenses. I think a lot of people, in a vacuum, expected that they were going to spend more on content next year than they did this year. That's been the pattern for a while.
Cross: And it probably will be. The nice thing we saw a little bit this quarter is, and they talked about this on the conference call, to be able to manage these costs, they have some flexibility. It's taking the costs across their entire platform. That's a real advantage that Netflix brings as a streaming service. Their profit margins compared to the likes of Comcast, for example, are half. But Comcast's legacy costs are so heavy, and the revenues are only growing in the single digits. I own both Comcast and Netflix in my portfolio, for different reasons. The cost structure is so different that Netflix long-term, we look out five, 10 years, the profitability picture and the ramp for them is so much more impressive than the likes of some of the established players. I think that's really what subscribers are buying. It's the ability to be able to grow the subscriber base. Streaming revenues spread those costs out by offering a product that is really superior in the marketplace that investors are excited about. Eventually, that will show up on the cash flow line.
Hill: I assume you own shares of Comcast because you're from Pennsylvania. I think that's a law in Pennsylvania, that you have to own shares.
Cross: [laughs] Yeah. The arm of the Roberts family goes very long.
Hill: This is a minor thing, but it's something I'm curious about with respect to Netflix. Where's the shop? Remember, they had some headlines a year or so ago? They had posted a job -- for a long time, that was my thing with Netflix. They have these successful shows that they are producing, and they own. Why aren't they making some gear? T-shirts, hats, mugs, etc. HBO does a great job, not just with original programming, but of selling any Game of Thrones paraphernalia that you want to get your hands on. HBO is happy to sell that to you. Where's the shop?
Cross: Maybe they should talk to The Motley Fool. We have some pretty nice swag that they could learn a little bit from.
Hill: [laughs] You know what? When The Motley Fool Podcast Swag Shop is up and running more quickly and selling more than the Netflix shop, that's my only point of concern with Netflix as a business.
Cross: It is interesting from the marketing side. They talked a little bit about this on the call, dialing back some of the marketing tactics and really letting the content speak. I think that's important. I think it actually is a very big driving point for Netflix to grow their subscriber counts. They have the content library, and they continue to add to that content library, and it's so diverse. The price point for members is so low compared to the competition that it really is a competitive advantage that's becoming harder and harder to match. Now, it's actually becoming a very profitable marketing component for them, that it will allow them to and maybe not have to spend so much on traditional marketing to grow subscribers.
Hill: Shares of IBM are hitting a 52-week low after IBM's third quarter report. Big Blue had grown revenue for three straight quarters. That streak is over now. To the extent that a $120 billion company can be in trouble, I look at IBM and... not that IBM is in danger of going away, but this is a stalled vehicle on the side of the road.
Cross: It sure is stalled. There had been some faint lights at the end of the tunnel here over the past couple of quarters, when they've been able to grow their quarterly revenues. That flipped this quarter. Their strategic imperatives, which is really their cloud business, their data analytics business, saw some stumbling blocks. Their growth slowed there. They saw a drop in new signings in that business. That stung a little bit. It's been a very tough go for IBM. Their best business this quarter, and really a lot this year, is their legacy mainframe business. That will tend to tail off next year.
There's a lot of excitement in their strategic imperatives in the investments they're making, crypto asset investments they're making, when it comes to cloud computing, when it comes to data analytics, the Watson side. But that's just a really long putt. For this, I really want to be a believer, just because the story of IBM. But I don't own shares, and I think following the direction of Warren Buffett, who exited most of the IBM positions in Berkshire Hathaway, is the way to go with this one.
Hill: Yeah. In some ways, that was a pretty damning, when Buffett sold out of that, when you consider some of the other things that he's held on to. You mentioned Watson. That's the thing that's a little surprising to me. Yes, there are lots of large tech companies that have cloud businesses. To my knowledge, IBM is the one that's got the most recognizable brand, the Watson brand, what they've done with that. The fact that they can't figure out a way to leverage that into a significantly growing business, and therefore a significantly growing share price, is troubling.
Cross: Also, there are 360,000 employees at IBM, I think is the number. We've seen this with General Electric, these big legacy enterprises, it's very hard to get these things turned around, especially in a market today that IBM is operating in. It has aggressive competition, very smart competition, upstart competition, that's been around and doing things very aggressively. IBM lacks a little that cachet. I agree. The Watson brand is extremely powerful. It's been a nice integration into IBM's business. But they haven't seen enough of the big wins to be able to grow the strategic imperatives. And the fact that it slowed a little bit this quarter, when that was really the bright spot that investors were waiting for -- they were expecting it to be north of 50% of revenues. It fell short of that this quarter on a trailing basis. The momentum is not with IBM, and clearly investors are selling off the stock today.
Hill: It's still a big business. Our email address is [email protected]. Question from Jason Long, who writes, "Your analysts do extensive research on companies, and there are plenty of resources out there to get information. I'm wondering, where would you recommend that I look if I wanted to find information about a public company's specific initiatives, future plans, or overarching goals during a certain time period? That is to say, how do I figure out the most important things the business is working on this year?" That's a great question!
Cross: It's a great question! I would say three very direct places. First, I would check out the company's website. So many companies now are offering up their strategic plans or their thinking or focus. You can get a good feel from what the website is talking about, what the business is talking about. So, first, there. Part of that website experience tends to be an investor relations area. You can go there to have a perspective on what they are talking about from the business. Netflix's investor relations area is extremely good, and they're very transparent with how they talk about their initiatives, including a whole section on long-term investments that they're making. So, I would say, the website; part of that is the investor relations department.
Second, the annual report. You can look up the annual report typically from the website. They all now list the annual reports, so you can look at the initiatives they're talking about in the business. I would say the annual report's a great spot.
Third, if you want to go look at the quarterly conference calls that sometimes are published on The Motley Fool's website and other websites, sometimes the companies publish them themselves. Sometimes you can access them, listen to them. Most companies now open those up.
Among those three areas, Chris, I think you get a very good feel of what management is talking about when it comes to the strategic initiatives that they're working on, what their expectations are, and how much progress they've made at those over the years.
Hill: Particularly on the conference calls. As you said, fool.com does this, there are other sites that do this, publish the transcripts. Jason Moser, from time to time, will just go to a conference call transcript and he'll just search for a particular word or phrase to see like, "I'm looking at this company and I'm curious to find out what they're doing in this one particular area. How many times are they talking about it? How many times are they asked? What sort of answers are they offering up."
Cross: Yeah, that's a great point. It allows regular investors, people who want to know more, to use the conference call transcript as a way to search for things very specifically. There's been fun stories about the growth on people and executives using terms like AI, or using cloud computing, and how that has just exploded, no matter what business you're in. You can be a floor manufacturing business now and they're talking about AI and cloud computing. Sometimes, you get a good sense, especially if you read those from quarter to quarter or look at them, of how to sniff out, let's just say a little bit of horse manure from what is actually true sometimes. That is one factor we do love to see in management teams -- they state what they're going to do, and they actually go out and deliver it, or they exceed that. That's been so impressive with the likes of Netflix over the last three to four years, when they've faced those doubters. Reed has been very bold out there talking about what they want to do from the content side, as well as the distribution side, and they've actually backed that up with deliverables.
Hill: Andy Cross, thanks for being here!
Cross: Thanks, Chris! It's been great!
Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening! We'll see you tomorrow!
