Netflix (NFLX -0.63%) delivered a stellar Q2 earnings report last week, with subscriber growth easily outpacing both the company's guidance and investors' expectations. But earnings are still lagging as the company invests heavily in new original content and global expansion.
Following the earnings release, Netflix's management team participated in its now-standard earnings interview with two industry analysts. Here are five key points that Netflix's leaders emphasized during the Q&A.
Aiming for steady domestic growth
We've been tracking at 5 million to 6 million net adds for several years now, and our hope is that we could just keep that going, 5 million to 6 million every year for a number of years. -- Netflix CEO Reed Hastings
Netflix's domestic subscriber growth abruptly slowed in mid-2014, causing the stock to crash late last year. Netflix ultimately added 5.7 million domestic subscribers last year, down from 6.3 million net adds in 2013.
However, growth has accelerated again in 2015. Netflix's domestic subscriber growth total was up more than 50% year over year in Q2. Netflix's management isn't counting on faster domestic growth, though. CEO Reed Hastings is merely looking for the domestic subscriber base to continue expanding at a steady pace of 5 million-6 million per year.
Strong content momentum
We have two things that are working for us. One, we're launching new shows that have become great brands on their own. But also, as these shows grow into their second and third and fourth seasons, they're actually more attractive on their own. -- Netflix Chief Content Officer Ted Sarandos
Original content is a key factor driving subscriber growth for Netflix, and offsetting any impact from market saturation in the U.S. But while Netflix has benefited from a number of hit original shows, some investors are worried that subscriber growth could slow if future Netflix originals aren't as well received.
Netflix's original content strategy has been a big success so far. Photo: The Motley Fool.
However, Netflix has had enough original content successes at this point that investors should be gaining confidence in the company's ability to pick winners. Moreover, there are big benefits to having an existing stable of hit shows. Netflix has ordered multiple seasons of most of its originals, creating subscriber growth opportunities each year when the new season comes out.
Boosting pricing
Over the last year, we've raised ASP about 5%. We'd like to keep that moving. ... but we want to take it very slow. -- Reed Hastings
With subscriber growth back on track, and Netflix usage at an all-time high, some investors are hoping that Netflix will start raising prices faster in order to bolster its profit margin. In the U.S., it raised the price of its most popular option -- offering up to two simultaneous HD video streams -- from $7.99/month to $8.99/month a little more than a year ago. However, that price increase hasn't even hit the majority of members yet, because existing customers were grandfathered in at the old price for two years.
Netflix plans to continue taking a conservative approach to price increases. Next year, it will benefit from the 2014 price increase hitting the "grandfathered" subscribers. It is also gradually convincing some customers to upgrade to an $11.99/month plan that includes four streams and ultra-HD content. But Netflix is unlikely to institute another broad-based price increase soon.
Free cash flow will continue to lag
We've done our best to indicate the trend that our free cash flow is going to diverge [from earnings]. And that's going to get worse as we invest more and more [in] content. -- Netflix CFO David Wells
The biggest red flag around Netflix's financial results continues to be its free cash flow. Original content tends to require front-loaded spending. Because Netflix is growing its original content library so quickly, cash expenses for content have been running at about 1.3 times the accounting expense shown in its financial statements. That ratio could peak at 1.4 in the near future.
As a result, free cash flow has plunged from $16 million in Q2 2014 to -$229 million in Q2 2015. Nevertheless, this result was in-line with Netflix management's expectations. And this number will get worse before it gets better.
Fortunately, interest rates are very low right now, so Netflix can borrow on the cheap to fund its content ambitions. As Netflix better leverages its content spending, and international losses slow in 2017 and beyond, free cash flow should become sustainably positive.
2016 will be the big year for international expansion
For Q4, we're focused on Spain, Portugal and Italy. Q3 being Japan. -- Reed Hastings
Netflix currently operates in more than 50 countries, mainly in the Western Hemisphere, but also including more than a dozen European markets, Australia, and New Zealand. It has announced ambitious plans to expand to nearly the whole world by the end of 2016.
However, most of that expansion won't be happening this year. Netflix will open in Japan later this quarter, and it is launching in Spain, Portugal, and Italy in October.
The rest of its global expansion is planned for 2016. That will make next year a very busy one for Netflix -- and also perhaps a year of steep international losses. But if Netflix becomes even half as successful in its new markets as it is in the U.S., that investment should be well worth the cost.
