With Netflix, Buy the Service -- Not the Stock

Shares of Netflix are down almost 14% this year. The company reports earnings Monday after the close -- and it was likely a weak quarter.
By Chris Laudani ,

Shares of Netflix (NFLX) - Get Report are down almost 14% this year. The company reports its second-quarter fiscal 2016 earnings Monday after the close. I am expecting a weak quarter.

In April, Netflix beat first-quarter estimates by 6 cents per share on revenue of $1.96 billion. Revenue rose 24%. Its U.S. contribution margin was up 120 basis points to 35.5%, well on its way to the company's goal of 40% by 2020. Net income was only $27.7 million.

Netflix added 2.2 million domestic and 4.5 million international subscribers. The growth in subscriptions came in ahead of expectations because of a series of strong movie and television show releases on the platform.

But at that time, the company implied second-quarter net international subscribers would be just 2 million, well below the 3.5 million the Street forecast. While Netflix bulls dismissed the guidance as simply cautious, others wondered why new subscriber growth would be so slow given the company's aggressive country expansion.

After all, Netflix is spending heavily to acquire new content in Japan, Germany, Italy, France and Spain. You would think with all that spending on local content, it would continue to aggressively add new international subscriptions.

Several countries -- like the U.K., Ireland, Canada, the Netherlands and much of Latin America -- will see price increases during the quarter, which may increase churn and slow net additions. Globally, Netflix now has approximately 80 million streaming subscribers.

During the quarter, Netflix spent heavily on new content. Content obligations rose 13% to $12.3 billion. The heavy spending continues to drive free cash flow lower. Free cash flow was a negative $260 million. Last year the company burned through $920 million to acquire new content.

At the end of the first quarter, Netflix had over $12 billion in off-balance-sheet content liabilities. Because of the heavy spending on new programming, Netflix will have to issue another huge slug of junk bonds later this year or early next year.

For the second quarter, analysts are looking for revenue of $2.11 billion, up 28%, and earnings per share of 2 cents. The company is expected to end the second quarter with 47.5 million domestic streaming subscribers and 36.6 million international subscribers.

Netflix bulls need the company to continue to add subscribers at a rapid pace. In fact, they must believe the company can grow subscribers at a 20% annualized growth rate for the next five years if it is to hit its goal of 200 million subs.

According to media reports, Netflix and Comcast (CMCSA) - Get Report reportedly agreed to allow Netflix content to stream through Comcast's X1 platform, potentially reaching Comcast's 23 million subscribers, which could help Netflix add additional subscribers in North America.

Analysts expect Netflix will end the year with revenue of $8.7 billion, up 29% and earn 27 cents per share. The company is expected to earn just $127 million in net income.

Obviously, with those numbers, it is difficult to value the stock on a traditional multiple basis.

Personally, I think the stock is played out and has seen its highs. Total operating expenses are rising faster than sales. For example, last year, expenses rose 39.5%, while sales rose just 23%. This year, analysts are looking for 29% revenue growth and 26% expense growth, but they were wrong in the first quarter. First-quarter revenue grew 24%, while expenses rose 25%.

Netflix has to grow revenue an average of 32% the second half of the year for expenses to grow less than revenue. I don't think that will happen.

I think Netflix has a wonderful product. I would buy the service -- not the stock.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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