After reporting disappointing results for the second quarter -- and with new competition from Walt Disney (DIS -1.83%) and many other competitors set to arrive over the next year -- Netflix (NFLX 2.50%) desperately needed to deliver better results in Q3.
In one sense, it succeeded. On Wednesday afternoon, Netflix reported that it blew past its earnings forecast, as well as analysts' estimates. That said, subscriber growth continued to slow in percentage terms, particularly in the U.S. Moreover, management made it clear that the deceleration in spending growth that enabled its big third-quarter earnings beat was just a blip. As a result, Netflix will struggle to generate the long-term growth in cash flow needed to justify its lofty valuation.
Earnings soar despite another subscriber miss
Three months ago, Netflix projected that it would add 7 million paid subscribers in the third quarter, up from 6.07 million paid net additions in the prior-year period. Management forecast that this would drive strong margin expansion, enabling Netflix to post operating income of $833 million, compared to $481 million in Q3 2018.
Ultimately, Netflix fell just short of its subscriber growth target, growing its global paid user base by 6.77 million. The shortfall came in the U.S., where net additions totaled just 520,000, well below Netflix's guidance of 800,000. Nevertheless, revenue surged 31.1% year over year to $5.25 billion, reaching the company's target, thanks to a 12% year-over-year increase in average revenue per user (in constant currency).
The most impressive aspect of Netflix's Q3 performance was its margin expansion. Operating margin reached 18.7%, compared to 12% a year earlier. Thus, operating income doubled to $980 million and earnings per share jumped 65% to $1.47, smashing the average analyst estimate of $1.04.
But Netflix expects a sharp reversal in the fourth quarter
Netflix achieved last quarter's profit surge by holding back the growth of its content and marketing costs. Most notably, it spent $554 million on marketing, down 8.2% sequentially and up just 8.5% year over year. However, cutting back in these areas isn't sustainable, as it will only aggravate the problem of slowing subscriber growth. With Disney and Apple set to launch their new streaming services next month, it's particularly important for Netflix to up its game with respect to content and double down on marketing.
That's a big reason why Netflix expects its operating margin to recede to 8.7% in the fourth quarter. (This would mimic a similarly sharp sequential profit decline between the third and fourth quarters of 2018.) Furthermore, Netflix maintained its full-year guidance for cash burn of about $3.5 billion, which implies record cash burn of $1.9 billion for the fourth quarter.
Netflix does expect free cash flow to begin improving next year. However, the need to invest heavily in new content and marketing to compete against the likes of Disney+ -- particularly in light of the low price point Disney has chosen -- will prevent Netflix from achieving the rapid cash flow growth that the most bullish analysts have expected.
Sure enough, in its recent investor letter, management referenced "slowly" moving toward positive free cash flow. This suggests that a 2018 Moody's report projecting that Netflix would turn cash flow positive by 2022 may have been overly optimistic.
Netflix stock is flying too high
Netflix's Q4 guidance calls for subscriber growth to slow again on a year-over-year basis, although management hinted that this forecast may be conservative due to uncertainty about the effect of new competitors and the success of new content that Netflix is launching this quarter. But even if the company beats its subscriber guidance, it wouldn't make the stock a good buy at its current price.
While Netflix stock sits well below the all-time high it reached last year, the streaming video pioneer still has an enterprise value around $140 billion. That's a massive number for a company that has consistently produced negative free cash flow in recent years. To warrant this valuation, Netflix would need to generate enormous amounts of free cash flow in the future.
It's getting more difficult to envision a pathway to that outcome. It could take until 2023 or 2024 just to reach cash breakeven. By that point, Netflix is likely to have fully saturated the U.S. and Canada markets, and many of its older, developed-country markets would be approaching saturation as well. Netflix would have to rely primarily, then, on price increases rather than subscriber growth to maintain a high rate of revenue growth.
However, the availability of lower-priced streaming services like Disney+ will make it harder than ever to push through additional price increases. Netflix certainly has enough room for subscriber growth and price increases to be solidly cash flow positive a decade from now. But it is unlikely to generate the extraordinary profits and cash flow that it would need to achieve market-beating stock performance.