When you combine Netflix's (NASDAQ:NFLX) post-earnings sell-off in July with a U.S.-China trade-war-induced pullback in the overall stock market, the streaming-TV giant has been beaten down and failed to recover. Shares are down 18% since the company reported earnings on Jul. 17.
But has the market overreacted? More importantly, is this a buying opportunity for investors?
Why the Street may be wrong
The main reason for Netflix stock's recent decline was the company's worse-than-expected net member additions in its second quarter. U.S. member trends, in particular, sparked concerns. Domestic paid memberships fell from 60.2 million in Q1 to 60.1 million in Q2.
But a closer look at the quarter reveals there's no reason to worry about the company's growth prospects. For instance, though Netflix only added 2.7 million paid members during the quarter (below its guidance for 5 million), total paid streaming members were up 22% year over year. Meanwhile, domestic paid memberships were up 7% from the year-ago quarter. That means Netflix grew its domestic base of subscribers by more than 4 million since the second quarter of 2018 -- not bad for the company's oldest and most saturated market.
In addition, investors should realize that Netflix's forecasts aren't conservative. Instead, management aims for accuracy with its forecasts. In other words, the company is going to occasionally miss its guidance -- likely more often than companies that adopt a lowball approach.
Last, some of the members Netflix expected to add late in Q2 may have simply joined early in Q3 instead as the company provided a robust outlook for its third quarter, guiding for 7 million paid member additions during the period. "Q3 has started with Stranger Things season 3, and the first two weeks of Q3 are strong," the company said in its second-quarter shareholder letter when discussing its membership trends. Similarly, Netflix's first-quarter paid member additions were exceptional, coming in at 9.6 million and crushing the company's guidance for the metric. There may, therefore, have been some pull-forward from Q2 into Q1.
Given Netflix's strong first-quarter member additions and management's optimistic outlook for Q3, Q2's lower-than-expected member growth isn't enough to start worrying about the company's ability to attract new customers.
Further, with so much focus on Netflix's quarterly paid member additions, it's easy to forget how fast the company's business is growing from a financial perspective. Netflix's 2018 gross profit was $5.8 billion, up from $4 billion in 2017 and $2.8 billion in 2015. Even more pronounced is Netflix's growth in annual net income, which increased from just $187 million in 2016 to $1.2 billion just two years later.
Sure, Netflix is still burning through significant cash. Free cash flow was negative $3 billion in 2018 and will likely come in around negative $3.5 billion for the full year of 2019. This is due to the significant upfront costs of building a library of high-quality content.
Over time, however, management believes these investments will pay off in member growth and retention as its content will continue to entertain users for years to come. And given how the company's strategy of releasing droves of original content has paid off in member growth, customer loyalty, and pricing power, management's expectation makes sense.
Better yet, the company expects 2019 to be the trough for the company's free cash flow trends, with the metric improving in 2020 and beyond as it grows its member base and expands its operating margin, thanks to the company's scalable business model.
While I'd like to see shares dip lower before buying a meaningful position, this does seem like a good price at which to start a small position in an outstanding company.