NFLX – Q2 Pushes The Share Price To Fair Value

Nice beat – Netflix is up 13% since reporting Q2 results and its Q3 outlook Monday night. The price is up primarily due to reporting net subscriber additions that were materially higher than their guidance.

Traditional Financial metrics were inline – The income statement was generally inline with our estimates and market consensus. Q2 Sales were $2.79 billion (beat our estimates by less than 1%, but was up 32% Y/Y), operating margin was 4.6% (vs. 3.3% last year and 9.7% last quarter due in large part to the shift of House of Card’s costs to Q2). Diluted EPS of $0.15 was inline with estimates. Free cash flow was -$608 million versus our estimate of -$399 million. Sorry that you just read all of that.

Our Q3 forecast is generally inline with Netflix’s guide but will likely change – Based on the performance of content throughout the quarter, our forecast model is likely to change. At the moment we expect 4.4 million global net adds in Q3, leading to revenue of $2.95 billion. We are forecasting an operating margin just short of management’s guidance of 6.7% and a diluted EPS of $0.27.

Net subscriber additions are the key metric – Netflix is technically a subscription based growth company with content costs accounted for in cost of revenue, As a result, Netflix can and we believe is being valued as a SaaS company.

The company can be measured using the inverse of churn (length of time an average subscriber stays) multiplied by the gross margin of new customers. This gives us the customer gross profit lifetime value (CLTV) divided by the R&D and sales & marketing expenses aka customer growth costs (CGC). CLTV / CGC is an under-utilized SaaS metric that works well in valuing the company.

As a result of steady pricing Globally and churn not being reported, net subscriber additions is the key statistic provided by Netflix to determine customer lifetime value. Based on our U.S. consumer survey, we estimate a Netflix U.S. subscriber is worth in excess of $300.

Next quarter, Netflix expects to have more U.S. subscribers than all U.S. cable companies  – Netflix’s 1.07 million Q2 U.S. net subscriber additions were materially higher than their 600,000 net subscriber additions guidance. This brought U.S. Netflix subscribers to 50.3 million, which is pacing to surpass U.S. cable subscribers for the first time by Q3 (51.0 million U.S. cable subscribers in Q1 and going down 100K+ a quarter as per Leichtman Research). Doesn’t really mean anything but it is still kind of interesting.

International disruption is still in the very early innings – Internationally Netflix reported 4.14 million net subscriber additions versus their guide of 2.6 million and our estimate of 3.02 million. This increased their total Global membership by 5% to 105 million. The Global Pay-TV market is generally thought to be just under one billion households.

Why did Q2 beat? We believe that these net subscriber additions are being driven by:

1. A reduced churn rate that may be below that of cable companies according to our surveys
2. Increased interest of NEW Netflix Originals around the World as per Google Trends. This includes impactful original content released near the start of the quarter such as “13 Reasons Why.” We believe our model missed Q2 results due primarily to not giving enough of a weighting to popular new shows.

“13 Reasons Why” has redefined how we model the potential impact of new shows. Netflix management noted that they have re-calibrated how to forecast the impact of shows as well. We believe they are have made similar changes as we have to their forecast model.

Source: Vimeo

Survey results on churn help with a real valuation – While Netflix stopped reporting churn in 2011, we surveyed about 600 people in the U.S. and Mexico and received an approximate churn rate. Details of which are available to subscribers. This metric has been used in our prior CLTV calculation.

In our communications with Netflix it was said that the general belief of the investment community is that their churn was above that of cable companies. That would imply a churn rate at 30% or above. A 30% churn would have been outside the margin of error of our recent surveys of the U.S. and Mexico.

Netflix’s current valuation – As per our calculations, the CLTV/ TTM CGC ratio is down from 1.6x in Q1 to 1.1x assuming a 30% churn. The higher net subscriber additions generally increases everybody’s expectations of the rate of growth for Netflix subscribers in the future. However, the bigger impact on the CLTV valuation is the higher amortization of content costs. We will discuss the amortization of content costs and how we track Netflix content in a later article.

The combination of the lower CLTV / TTM CGC and higher share price has pushed NFLX to a relative hold in our opinion.

EXHIBIT 1: Netflix SaaS Metrics Prior to the Q2 Earnings Report

Source: Perspectec and Company reports

EXHIBIT 2: Netflix SaaS Metrics Post The Q2 Earnings Report

Source: Perspectec and Company reports

We are closing our first Netflix Relative Stock Call Subscription – Based on the shift into relative hold territory (between the two lines), we have closed our Netflix Relative Stock Call Subscription #1. We believe the valuation catch-up trade has largely taken place. The final closing return will be based on the average
opening and closing prices on July 21, 24 and 25, 2017.

The relative stock call involved buying Netflix (up 26% since initiating the call). In the 15 days since initiating the relative stock call subscription, the trade has resulted in an absolute return of 11%. On an annualized basis, this trade returned 1,232%.

Subscribe to the Netflix Research Plan for more details as to when and if we see another investment opportunity with NFLX.

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