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Netflix Q3 highlights growth, uncertainty as competitive pressures mount

Netflix Inc.'s quarterly earnings revealed Wall Street's worst fears had not come to pass, but with Disney+ set to bow in the fourth quarter, its biggest competitive test yet may lie ahead.

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Netflix's stock initially jumped after it reported earnings Oct. 16 but then seesawed as investors and analysts digested the company's acknowledgment that rising competition from The Walt Disney Co. and other deep-pocketed rivals is likely to lead to tougher times in the near-term. The company lowered its fourth-quarter subscriber expectations and shifted its marketing budget as it prepares for Disney+ to drop Nov. 12. It now expects total full-year net additions of 26.7 million, down from 28.6 million in 2018. The full-year 2019 projection includes 7.6 million global net additions for the fourth quarter.

Netflix has long fueled its international and original content expansion with debt, and given the current dynamics, analysts said it could be a long time before the company is able to generate positive free cash flow.

"In spite of four Netflix price increases in the last five years, cash burn continues to grow," wrote Wedbush equity analyst Michael Pachter in a post-earnings note. "Content migration to competing services and price hikes may slow subscriber growth and [drive] increasingly negative FCF [free cash flow]."

Yet sentiment on Netflix had turned bearish heading into the third-quarter earnings report, and investors bid up the shares following a net subscriber growth result that missed Netflix's forecast but came in much closer to expectations than the second quarter, when Netflix reported its first-ever decline in domestic streaming subscribers.

"We believe expectations for international subs had been trimmed materially going into earnings, which likely explains the post-close outperformance in the stock despite the weak Q4 guide," wrote Barclay's equity analyst Kannan Venkateshwar, who maintained an "overweight" rating and $375 price target on the stock. "[The] Q4 guidance appears to have been adjusted for the launch of Disney+, elevated churn and uncertainty due to a movie heavy release calendar."

The fourth quarter will see Netflix drop a run of high-budget, high-profile films like the $140 million "Irishman," rather than a new or well-known series, which the company acknowledged could impact churn, or the pace of customers exiting the platform. CFO Spencer Neumann said the company was taking a "prudent" approach to its fourth-quarter expectations in light of the shift in its content release slate.

The company also cited prolonged churn from its price increase earlier in the year and the rise in competition from upcoming streaming launches as factors in its more conservative guidance. "On the negative, the guide is a miss and these factors are not new. On the positive, the guide feels a little more conservative/de-risked," SunTrust Robinson Humphrey equity analyst Matthew Thornton said in an earnings note.

The analyst maintained a "buy" rating and 2020 price target of $402, though he said his valuation and models were under review.

Netflix maintained its 2019 operating margin guidance of 13% and its free cash flow guidance of negative $3.5 million. So far, it has been able to increase revenue and profitability while adding international subscribers, despite slowing domestic growth. The company forecasts its operating margin will climb to about 13% in 2019 from about 10% in 2018 and 7% in 2017. Revenue grew 31.1% year over year to $5.24 billion in the third quarter, while the cost of revenues, which includes content but not marketing costs, climbed about 22.6% to $3.10 billion.

Chief Content Officer Ted Sarandos estimated the cost of a television series was up about 30% over the past year as the company pursued more ambitious projects. "I would say the exciting thing about this moment in entertainment history is that the scope and scale and ambition of television is beginning to rival that of feature film, which is an incredible win for consumers," Sarandos told analysts on the Oct. 16 earnings call. Given Netflix's $15 billion content budget and expansive global membership, executives said the company was well positioned to continue delivering the type of content that attracts and retains subscribers.

However, many analysts are increasingly dubious that Netflix can support its pure-play subscription strategy, fund a competitive content slate and improve its cash flow.

"There is increased uncertainty as to whether new competition will slow growth and can the company indeed reach a point where it can fund required content investments with internally generated cash," Fitch Ratings credit analyst Patrice Cucinello said in her earnings response. "In the interim, Netflix will remain reliant on the debt capital markets to fund its sizeable albeit slowly declining FCF deficits."

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