Netflix (NFLX -1.74%) wowed the market with its first-quarter earnings report Tuesday.
The leading streamer saw a surge in new members with 15.8 million subscriber additions as the stay-at-home orders around the world have driven demand for in-home entertainment options like Netflix.
The market's response was tepid, however, as CEO Reed Hastings cautioned that much of that subscriber growth represented members being pulled forward from future quarters, so he expected growth to cool off year-over-year in the second half of the year. Netflix's quarterly revenue was also just slightly ahead of expectations, at $5.76 billion compared to $5.73 billion, due to a stronger U.S. dollar, while earnings per share of $1.57 was below its forecast of $1.66 due to incremental spending on paused productions and hardship funds to help support unemployed production workers.
Shares of the streamer had soared over the last month to new all-time highs as Wall Street seemed to have already factored in the subscriber surge. At one point, the stock had bounced more than 50% from its March lows. However, Netflix itself is uncertain about where subscriber growth goes from here as it forecast 7.5 million second-quarter additions, a strong pace for the spring period, but also acknowledged that the forecast was mostly guesswork.
Still, one thing is clear from the quarterly report as well as Netflix's progress in recent years. The streamer is turning into an undeniable profit machine.
Netflix bears have long questioned the company's cash-burning strategy. In order to make original TV and movies, Netflix has to spend heavily up front, and it only recoups those costs years later from subscription revenues as the product streams on its service.
Free cash flow came in at negative $3.3 billion last year, which Netflix expects to be a trough, and it's had to take on a substantial amount of debt to fund that strategy. In fact, it announced another $1 billiion debt offering Wednesday morning. However, one of the silver linings from the pandemic is that Netflix has been able to save on cash costs with production on pause, and the company now expects free cash flow of negative $1 billion or better for 2020, though management sees a return to its general trajectory toward positive free cash flow next year. The company does not have a specific target for generating a free cash flow profit.
What's been overlooked in the debate about cash flow is that Netflix's profit margin is based on generally accepted accounting principles (GAAP). Netflix's operating margin surged to 16.8% in the first quarter, putting it in league with highly profitable cloud services and legacy tech companies, and that mark was actually below the company's forecast of an 18% margin. Operating income more than doubled in the first quarter, reaching nearly $1 billion.
Netflix continues to target a 16% operating margin for 2020 and sees that figure rising to 17.9% next quarter. Operating margin should continue to improve next year and beyond as the company digests the heavy upfront costs it's paid for programming in recent years, and as it leverages its subscription model.
With the strong improvements in profit margins, Netflix is starting to look cheap, at least on a relative basis, as its P/E ratio, including the forecast for the second quarter, is less than 70, the cheapest it's been in years.
Where Netflix goes from here
Like the rest of the business world, Netflix is in uncharted territory with the coronavirus pandemic, but it's clear that the streamer is gaining a signficiant tailwind from the stay-at-home orders. In Europe, which experienced the shutdown protocols before the company's other regions, the streamer added nearly 7 million members, close to half of its growth in the period. However, the company was cautious about future growth.
"Some of the lockdown growth will turn out to be pull-forward from the multi-year organic growth trend, resulting in slower growth after the lockdown is lifted country-by-country," Netflix wrote in its shareholder letter. "Intuitively, the person who didn't join Netflix during the entire confinement is not likely to join soon after the confinement."
Management also threw cold water on the idea of price increase in the near future on the earnings call, which would follow a substantial hike about a year ago, as the company seems to understand that the global economy has been wrecked by the pandemic and has other areas demanding its attention, like restarting production once shutdown orders are lifted.
That means that, barring currency fluctuations, Netflix's revenue growth will moderate once the boom from the stay-at-home orders fades and as the company laps last year's price increase. However, just as the top line decelerates, the bottom line is surging as the most recent results and Netflix's operating margin targets show. In other words, Netflix stock has earned the all-time high and is primed for more long-term gains.