On Wednesday afternoon, streaming video market leader Netflix, (NASDAQ:NFLX) reported another quarter of stellar subscriber growth. By the end of June, its global subscriber base eclipsed 65 million users, up from just 50 million a year earlier.
On the other hand, this strong subscriber growth isn't leading to strong profitability for Netflix. Instead, the company continues to operate a little above breakeven. That said, if Netflix can maintain its subscriber momentum for a few more years, it should be able to leverage its expenses and start churning out significant profits.
Q2 by the numbers
In Q2, Netflix produced revenue of $1.64 billion: up 23% year over year. That was essentially in line with what analysts expected, despite an $83 million negative impact on international revenue caused by the strong dollar.
EPS was $0.06, beating the average analyst estimate of $0.04. Netflix's 7-for-1 stock split went into effect on Wednesday -- based on the pre-split share count, EPS would have been $0.42: slightly ahead of Netflix's guidance of $0.38. However, that was down significantly from Netflix's EPS of $1.15 in Q2 2014.
Subscriber growth exceeded management's expectations both within the U.S. and internationally. In the domestic market, Netflix added 0.90 million subscribers, after adding only 0.57 million domestic customers in Q2 2014. This was truly a remarkable result given that seasonally, Q2 is the weakest quarter for Netflix. It easily beat the company's guidance for 0.60 million net additions.
Meanwhile, Netflix added 2.37 million international subscribers in Q2. That was more than twice as many as it added in the same period last year, largely because Netflix is available in significantly more countries now. This comfortably beat management's guidance for 1.9 million net additions in international markets.
The biggest negative was on the free cash flow front. Netflix burned through $229 million of cash last quarter, after generating free cash flow of $16 million in the prior-year period.
Scoring Netflix's performance
Last week, I highlighted three key items that investors should keep an eye on in Netflix's earnings report. These were: 1) Netflix's ability to post significant growth in a seasonally weak quarter; 2) domestic content cost growth; and 3) the impact of the strong dollar on international profitability.
Based on the strong subscriber growth described above, Netflix clearly passed the first test with flying colors.
Domestic content cost growth did accelerate in Q2, with the domestic "cost of revenues" line rising by $30 million sequentially to $613 million. That was nearly as big an increase as in the three previous quarters combined. However, it was better than the $40 million (or greater) increase I had feared -- and it's very manageable given Netflix's accelerating subscriber growth.
Finally, the $83 million international revenue impact was clearly significant, but Netflix still managed to limit its international contribution loss to $92 million, versus guidance for a $101 million loss. Once again, stronger-than-forecast subscriber growth likely played a key role.
Looking ahead to Q3, Netflix expects another quarter of strong subscriber growth. It is calling for 1.15 million domestic net subscriber additions and 2.40 million international net additions. Both figures are more than 10% above the comparable figures from Q3 2014, suggesting that Netflix's growth will accelerate on a year-over-year basis for a third straight quarter.
Netflix also expects EPS to improve modestly on a sequential basis to $0.07. The domestic streaming contribution margin is expected to decline slightly due to higher costs; but on the flip side, Netflix projects that its international loss will narrow in Q3 before accelerating again as it expands to new markets this fall.
In short, Netflix delivered just about everything that investors could have asked for last quarter. Not surprisingly, investors sent the stock up about 10% in after-hours trading, to what would be a new all-time high.
That said, Netflix is still barely profitable, due to its massive investments in original content and global expansion. The company will need to deliver many more quarters of stellar growth to go from burning hundreds of millions of dollars of cash to becoming a cash cow worthy of its nearly $50 billion valuation.