Netflix (NASDAQ:NFLX) recently reported fourth-quarter 2018 results, and while the stock sold off after the release, that came after the stock had already run up some 35% in just three weeks to start 2019. In fact, there was quite a bit of good news to go around, despite the market's negative reaction.
Netflix stock is currently quite volatile. On the one hand, its superior competitive position in global video streaming continues to fuel the bull case. On the other hand, skeptics continue to point to low margins, billions in negative free cash flow, and looming competition.
The earnings report appeared to provide ample fuel for bulls and bears alike. Let's dive into each argument and why I lean toward the bull side.
Food for bears: Contribution margin declines
Bears would likely point out the rather large decline in Netflix's contribution margin last quarter. Contribution margin describes a company's revenue minus its variable costs -- for Netflix, essentially its revenue minus content, marketing, and delivery costs (but excluding technology costs and general and administrative costs). While Netflix has traditionally had a low operating margin, its contribution margin in the U.S. has been quite strong and its international contribution margin has improved over time. This has led bulls to believe that Netflix will be massively profitable as it scales over its fixed costs.
Yet in Q4 2018, Netflix's U.S. contribution margin declined to 29.6%, down from 35.5% in the previous quarter, and its international contribution margin fell to just 3.9%, down from 11% in the previous quarter, on the back of increased content and marketing costs.
Furthermore, free cash flow was negative $1.3 billion in the quarter and negative $3 billion for the full year. Skeptics would likely also point to management's forecast for a similar level of cash burn in 2019.
A retort from bulls
Bulls, as usual, have an answer for Netflix's margin declines and negative cash flow. First, the lower contribution margin is likely due to the timing of new releases. When Netflix releases a show, it recognizes associated amortization and marketing costs. Netflix released tons of content around the holidays, including hits like The Haunting of Hill House, The Kominsky Method (which just won a Golden Globe), the film Roma (which also won a Golden Globe), and Bird Box, which was watched by 80 million households in its first four weeks, according to management.
Looking back to 2017, Netflix also posted its lowest contribution margin of the year in Q4, following a similar content drop late in the year. That didn't stop its contribution margin from bouncing back strongly in the first three quarters of 2018. Looking ahead to Q1 2019, management guided to a 34.2% U.S. contribution margin (up 4.6 percentage points sequentially) and a 9.8% international contribution margin (up 5.9 percentage points sequentially). For the full year, Netflix estimates that its operating margin will increase to 13% from 10% in 2018.
And while the company did guide for similar ($3 billion) negative free cash flow for 2019, management also said that cash flow should "improve each year thereafter." So it appears that we will get a sense of Netflix's real cash flow potential in the 2020s, and no earlier.
Finally, bulls can also hang on to the better-than-expected subscriber numbers, which clocked in at 8.8 million net additions globally (1.5 million in the U.S., 7.3 million internationally), beating guidance of 7.4 million net adds. As CEO Reed Hastings said on the Q3 call, he thinks of current free cash flow losses as investments in gaining future subscribers. These strong subscriber gains perhaps gave Netflix the confidence to raise prices again early in 2019.
You is why I lean bullish
While there's merit to both sides of the debate, I still lean bullish. A good example of why was exemplified in Netflix's recent release, You. You is a creepy show about a bookstore manager (Penn Badgley) who stalks a young writer (Elizabeth Lail) in New York City. It initially premiered on Lifetime in September 2018, but Lifetime canceled it after its first season, as the show only garnered an average of 680,000 viewers per episode.
Netflix then swooped in and bought the show, which it will renew for a second season. Though the first season of You premiered on Netflix on Dec. 26, management estimates it will be watched by 40 million households within the first four weeks of airing.
I don't know about you, but when one cable channel releases a show that garners 680,000 viewers per episode and another channel releases the exact same show three months later and it gets 40 million viewers, I'd say the latter has a sizable competitive advantage.
The case study of You is why I still hold shares in spite of Netflix's heavy spending.