Netflix (NFLX -0.51%) dropped its first-quarter earnings report Tuesday afternoon, and the update was a mixed bag.
The leading streamer continued to grow at a sluggish pace as the company adapts to increased competition, a maturing market in North America, and the threat of a recession in much of the world, but it's also making progress in key growth areas like advertising.
Revenue in the quarter grew just 4%, or 8% on a currency-neutral basis, to $8.16 billion, which was slightly below estimates at $8.18 billion. The company added just 1.75 million subscribers in the first quarter, usually a seasonally strong period for the company, and it reported earnings per share of $2.88, edging out estimates at $2.86.
Investors initially sold the stock off on the report, balking at a delay in its rollout of "paid sharing," or its effort to crack down on password sharing and drive new member sign-ups. However, the stock was trading roughly flat around 5 p.m. as investors had a chance to digest the news.
Netflix raised its free-cash-flow guidance for the year from at least $3 billion to at least $3.5 billion as it said content spending would be lower than it expected. For the second quarter, it forecast similar results to the first quarter, calling for 3.4% revenue growth to $8.24 billion and EPS of $2.84. Those were both below the analyst consensus.
The chart below shows a breakdown of the company's revenue and expenses in the quarter.
Image source: The Motley Fool.
The decline in operating income was primarily due to a stronger dollar, which makes international revenue worth less.
However, the most important item in Netflix's report wasn't in the numbers, but buried deeper in the shareholder letter.
Advertising shines
After years of resisting, Netflix finally launched an ad-based tier last November, making the service available for a lower price with ads in 12 countries.
Early reports showed the company struggling to deliver the ad-supported viewership that it had promised advertisers, but Netflix seems to have reversed that problem in the first quarter.
Management said that the average revenue from its ads plan in the U.S., combining subscription and ad revenue, is already above its standard plan. Netflix's Basic with Ads plan is priced at $6.99/month while its standard plan is $15.49/month, so the company is bringing in more than $8.50/month per subscriber, making it already more successful than Hulu's ad business on a per-subscriber basis.
Because of the success of the advertising revenue stream, the company is investing more resources into improving the ad tier. It's upgrading the video quality from 720p to 1080p, and it's allowing ad subscribers to have two simultaneous streams, rather than just one as they're limited to on the ad-free Basic plan.
Netflix also said that it's seen very little switching from standard and premium plans to ad tiers, a sign that the ad tier isn't cannibalizing existing accounts, but bringing in new members and converting ad-free Basic subscribers, at $8.99/month, to higher-monetizing plans.
Why it matters
Advertising has the potential to be a massive revenue stream for Netflix, even matching is ad-free business, and advertisers are clearly hungry to partner with Netflix, given its subscriber base of more than 200 million households around the world.
The success of the ad tier not only shows that the ad business should continue to grow, but it will also give the company cover to raise prices both on subscribers and advertisers to grow revenue over the long term.
Netflix is unlikely to raise prices in the near term as it just raised prices last year in the U.S., but the choice to add another stream to the Basic with Ads tier could persuade some members on the standard tier to switch to the Basic with Ads plan, which would be revenue-positive for Netflix.
It should take a few quarters for the impact of the ad tier to become visible in the results, but management said it expected revenue growth to reaccelerate in the second half of the year with the help of paid sharing and the growth of advertising.
After several quarters of single-digit revenue growth, Netflix may not be the growth stock it used to be, but it also isn't priced like one. If the company can deliver on that promise in the second half of the year and continue to gain traction with its advertising business, the streaming stock looks like a good bet to beat the market this year.
