Netflix Drops Post Earnings, But Is It Justified?

Key Points

• A mixed earnings report was released last night. 
• Shares dropped 12% in the after hours session before snapping back.
• The short term outlook remains murky, but the longer term is appealing. 

A 12% slide in yesterday’s after-hours session might have been about the last thing Netflix Inc NASDAQ: NFLX investors expected, let alone wanted. But such was the initial reaction to the streaming giant’s Q1 earnings which were released after the bell. While shares managed to recoup almost all that drop by the time the after-hours session ended, it was still a worrying sign.

Let’s take a look at the numbers and see if this was a justified drop, if it’s a sign of things to come, or if it’s perhaps opening up an interesting entry opportunity. 

For starters, a marginal beat on the EPS did little to mask the miss on the company’s revenue for the quarter, which was up less than 4% year on year. The average revenue per subscriber declined slightly, though subscriber additions did beat expectations. These kinds of metrics are indicative of a company whose business model is maturing, and it will require nimble and adaptive leadership to make this a net positive. 

Looking Ahead

To that end, Netflix announced what was called a "broad rollout" of its paid-sharing initiative, the goal of which is to crack down on password-sharing, in the second quarter. Leadership stated that it was pleased with the results of the initiative's launch in the first four countries during Q1. In addition, it was said that Netflix’s advertising approach, particularly in the U.S., has shown "healthy performance and trajectory". So much so that the company is comfortable upgrading its ads experience with more streams and improved video quality to attract a broader range of consumers.

However, Netflix's operating income dipped to $1.7 billion from a year ago's $2 billion, and the company’s operating margin fell to 21% from a year ago’s 25%, which the company attributed to the strength of the US dollar. Looking ahead, they expect this to remain a headwind in the coming quarter, with Q2 operating income anticipated to be roughly flat while Q2’s operating margin should be around 19% from a year ago's 20%. 

It certainly wasn’t the knock-out result that the bulls were hoping for, nor is it likely to start a raging rally anytime soon. But the drop and immediate snap back in yesterday’s after-hours session is interesting nonetheless. The stock had been moving well from last summer’s multi-year low through the end of January. It tacked on an impressive 130% over that timeframe but had cooled considerably over the course of February. Shares had been looking buoyant once again, but the weak headline numbers seen last night might prove too much to see them break $350 in the near term. 

Getting Involved

Still, that’s not to say there isn’t a longer-term opportunity opening here. Management can boast of a strong free cash flow, which at $2.1 billion was more than double the amount from the same period the previous year. The company's reduced content spending contributed significantly to this, and consequently, Netflix has raised its free cash flow forecast for the year to $3.5 billion. This upward revision is helping to drive the company's buyback program, which itself is expected to continue throughout the year.

The company in Q1 bought back $400 million worth of stock, and this is one of the strongest signals that management can give to the market. It essentially says they believe the share price is trading well below fair value and that they have confidence in it rallying considerably. 

Their Q2 guidance was indeed a bit worrying, but the longer-term plan to turn Netflix’s fortunes around appears to be on track. In fact, this was in many ways confirmed by the aggressiveness with which shares were snapped up last night after that initial dip. Let’s see how they trade for the rest of the week and keep an optimistic outlook that this is the start of the next chapter in the recovery.