Netflix (NASDAQ: NFLX) shares were down about 8% in pre-market trading Friday morning, but investors shouldn't be fooled by the sell-off. This was another rock-solid quarter for the streaming giant .
Boosted by tailwinds from the COVID-19 pandemic, Netflix posted strong results across all of its key metrics. It added 10.1 million subscribers in the quarter, well ahead of its guidance of 7.5 million. Revenue jumped 24.9% to $6.15 billion, beating its forecast at $6.05 billion and the analyst consensus of $6.08 billion.
Meanwhile, further down the income statement, the results were even more impressive. Its operating margin surged from 14.3% to 22.1%, and operating income nearly doubled from $706 million in the quarter a year ago to $1.36 billion, well past its own forecast of $1.08 billion. In addition to the strong subscriber growth, a decline in marketing spending in part due to the pandemic helped lift operating profits. Free cash flow came in at $899 million, compared to a loss of $594 million in the quarter a year ago, as the closely watched figure benefited from a cutback in production, again because of the pandemic. The only blemish in the report was that earnings per share came in below expectations, but that was due to $339 million in special expenses related to currency exchange and a change in a deferred tax allowance.
So why the sell-off?
Though management was clearly satisfied with the strong second-quarter performance, it's also sober about the second half of the year and expects subscriber growth to be slower than a year ago. It assumes that subscribers who would have joined the service later in the year have already signed up as the pandemic accelerated that decision.
Management is calling for subscriber growth of just 2.5 million in the third quarter, compared to 6.8 million a year ago. The summer months tend to be the seasonally slowest for Netflix, but that forecast still indicates a sharp drop-off in subscriber growth over the coming months. In fact, a chart showing monthly subscriber growth in the letter to shareholders seems to indicate that subscribers actually declined in June, though the company canceled lapsed accounts on the service as one of its pro-consumer policies, which it called "the right thing to do."
Netflix says that its guidance represents its best internal forecast at the time it provides it, but it usually beats its own subscriber forecast, and there's a high level of uncertainty this quarter given the effect of the pandemic, especially as the U.S. experiences a resurgence in coronavirus cases. That and the company's belief that subscribers were pulled forward mean third-quarter guidance is likely to be conservative, and subscriber growth is also more difficult to predict than it normally would be.
Netflix is still a no-brainer stock to own
While management is cautious about the second half, the pandemic is improving the company's prospects in multiple ways. Spending more time at home has led consumers to seek more video entertainment. Meanwhile, the linear TV ecosystem that Netflix competes directly with is reeling from an implosion in ad revenue and a lack of live sports, both of which could accelerate cord-cutting, further adding to the long-term pool of Netflix subscribers. As a subscription-based business model, Netflix is free from the advertising issues weighing on many of its peers. As an affordable, high-value service, it's likely to perform well even in a conventional recession if that's how the pandemic evolves.
Elsewhere, Netflix's fat profits show that its business model has never been stronger. The company is still targeting an operating margin of 16% for the year, which it will almost certainly beat, and is forecasting a 19% operating margin for 2021. Concerns about free cash flow now seem mostly irrelevant, as the pandemic shows that Netflix can crank out cash when it scales back on production. In fact, in the second quarter, amortization of content and cash spending on content was nearly identical, showing what a mature Netflix might look like, and the company generated a 15% free cash flow margin.
Netflix shares will continue to be volatile, like much of the stock market, as there's a lot of uncertainty around the pandemic. But the company could easily top its third-quarter guidance, and it continues to be head and shoulders above its rivals in viewing hours. With all of the pandemic-related momentum on its side and against much of the competition, the streamer has never been in a stronger position.
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Jeremy Bowman owns shares of Netflix. The Motley Fool owns shares of and recommends Netflix. The Motley Fool has a disclosure policy.
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