Shares of streaming-TV company Netflix (NASDAQ: NFLX) sold off sharply last week, following its second-quarter earnings report. While the quarter was characterized by strong growth and impressive operating margin expansion, some investors were spooked by management's underwhelming forecast for subscriber growth in Q3.
Here's a closer look at key takeaways the quarter, as well as some of management's view for Q3 and beyond.
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1. Netflix gets a co-CEO
Along with its quarterly results, Netflix notably announced it was promoting Ted Serandos to a co-CEO position, alongside founder and CEO Reed Hastings. Serandos, who was the company's chief content officer, will maintain that position while he serves in his new co-CEO role.
"Ted has been my partner for decades. This change makes formal what was already informal -- that Ted and I share the leadership of Netflix," said Hastings in the company's second-quarter shareholder letter.
2. New subscribers spiked
Netflix once again added more subscribers than expected during the quarter. Both new member acquisition and existing member retention were higher than anticipated, fueled by social restrictions due to COVID-19. Netflix added 10.1 million net paid members during the period, up from 2.7 million in the second quarter of 2019. Management had forecast 7.5 million new members during the period.
Putting the company's spike in subscriber growth into perspective, Netflix added 26 million paid members during the first half of 2020, rivaling the 28 million the company added during the entire year of 2019.
3. Robust operating income
Helping profitability during the quarter was Netflix's improving operating margin (operating income as a percentage of total revenue). The company's operating margin expanded 770 basis points year over year to 22.2%. This put operating income for the period at $1.4 billion.
While Netflix management does expect improvement in its operating margin over the long haul, the metric will almost certainly narrow before resuming its expansion. The key profitability metric benefited from abnormal subscriber growth and lower-than-expected content costs since the pandemic delayed some production investments.
4. Positive free cash flow
The same factors that helped Netflix's operating income also led to impressive free cash flow during the period. Free Cash flow was $899 million during the period, up from negative $594 million in the year-ago period. However, free cash flow improvement also reflects leverage in the company's business model as Netflix's huge cash investments in original content become a smaller portion of total revenue.
Of course, management forecast a return to negative free cash flow in 2021 as normal production spend resumes. Sometime within the next few years, however, management expects free cash flow to become consistently positive on an annual basis.
5. Slowing growth
Explaining why shares of the growth stock sold off last week when the company reported its second-quarter results, management's expectation for 2.5 million new members during Q3 was less than half of analysts' average forecast for the period.
"As we indicated in our Q'20 letter, we're expecting paid net adds will be down year over year in the second half as our strong first half performance likely pulled forward some demand from the second half of the year," management explained in Netflix's second-quarter shareholder letter.
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