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Netflix Just Failed a Big Test

Adam Levine-Weinberg, The Motley Fool

Six months ago, I described 2019 as "a make-or-break year" for streaming video pioneer Netflix (NASDAQ: NFLX). The company was in the midst of rolling out its most ambitious price hike in nearly a decade -- barely more than a year after a previous price increase. If it had been able to do so with no major impact on subscriber growth, Netflix would have demonstrated massive pricing power, supporting its lofty valuation.

Instead, subscriber growth slowed abruptly last quarter, as revealed in Netflix's recent earnings report. This is a big red flag for investors, as it suggests that Netflix's older markets are starting to reach saturation and that substantial price increases could drive customers away.

Balancing price increases with subscriber growth will be even trickier in the future, with a slew of rivals including Walt Disney (NYSE: DIS) set to launch new streaming services soon. As a result, Netflix stock doesn't look appealing, even after falling about 10% on Thursday.

NFLX Chart

Netflix Stock Performance, data by YCharts.

Growth nearly stalls out

Netflix posted a solid performance in the first quarter of 2019. While its revenue growth slowed and operating margin declined year over year, the company reported a record 9.6 million net paid subscriber additions for the quarter.

However, in conjunction with the earnings report, Netflix projected that net paid subscriber growth would fall to just 5 million in the second quarter. That would have been lower than the 5.45 million paid subscribers added in the prior-year period, which was itself a disappointing result.

The reality was far worse. Paid net adds came in at just 2.7 million last quarter, down more than 50% year over year. This included a slight decline in Netflix's domestic paid subscriber count -- the first drop since the company's failed attempt to spin off its DVD-by-mail business as a new company called Qwikster back in 2011. Globally, Netflix saw the most underperformance in markets where it recently raised prices.

To be fair, Q2 is always the weakest part of the year for subscriber growth. Netflix still ended the quarter with its global paid subscriber count up 22% year over year. It also acknowledged that it had a relatively weak slate of new content last quarter, and Netflix delayed some marketing spending to the second half of the year. All of those factors can help explain the subscriber miss last quarter. Nevertheless, the poor quarterly results don't bode well for Netflix bulls.

Why the slowdown seems significant

Globally, Netflix is still growing quickly. Revenue rose 26% last quarter, despite the negative impact of the strong dollar. Netflix is still relatively new to many of its markets, which is why its overall growth numbers look quite strong.

A Netflix content screen for Stranger Things

Netflix is now relying on international markets for the bulk of its subscriber growth. Image source: Netflix.

But in the U.S., there are clear signs that Netflix is reaching maturity. The company had 60.1 million paid subscribers in the U.S. as of the end of last quarter, up just 7.4% year over year. For comparison, the domestic paid subscriber base increased 11.2% over the prior 12-month period.

The result is that Netflix will need to rely on boosting prices to keep growing domestic revenue at a double-digit pace. That will become even riskier as competition mounts. Back in April, Disney announced that it would price its new Disney+ service at just $6.99 per month (or $69.99 for an annual subscription), dramatically undercutting Netflix.

Of course, many Netflix subscribers are fiercely loyal and would accept annual price increases. Furthermore, lots of people will subscribe to multiple streaming video services, so there won't be a zero-sum battle between Netflix and Disney+. But some customers may jump ship to cheaper entertainment alternatives if prices keep rising. Netflix risks getting caught in a cable-like quagmire where annual price increases lead to slow but steady attrition in subscriber numbers.

An even bigger problem for long-term investors is that many of Netflix's international markets are only a few years behind the U.S. in reaching maturity. Netflix's international revenue rose 32.6% year over year last quarter -- but it had surged nearly 65% year over year in Q2 2018. International growth will continue to moderate in the years ahead.

The forecast isn't good enough news

Netflix is planning for a much stronger content slate in the second half of 2019. It released the latest season of its hit show Stranger Things earlier this month, the final season of Orange Is the New Black will arrive later in July, and other key titles are set to launch in the coming months. As a result, management expects stronger subscriber growth over the next couple of quarters.

Netflix's Q3 forecast calls for 7 million net paid subscriber additions, roughly flat year over year. For the full year, the company still expects to add more paid subscribers than it did in 2018. That might seem to suggest that the slowdown last quarter is nothing to worry about.

It's true that investors shouldn't read too much into a single quarterly earnings report. That said, Netflix's domestic growth rate has been slowing for a long time. Furthermore, even if Netflix achieves another year of higher paid net adds, its growth rate will almost certainly be lower in percentage terms. Moreover, the company is launching a cheaper mobile plan in India this quarter -- reportedly priced at less than $4 per month -- which could inflate subscriber growth without adding much revenue.

Netflix doubtless has plenty of growth ahead of it, particularly in international markets. But its Q2 report provides yet more evidence that Netflix's growth prospects aren't sufficient to justify its valuation (which currently stands near $142 billion) given that the company is still years away from reaching breakeven on a cash-flow basis.

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Adam Levine-Weinberg has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Netflix and Walt Disney. The Motley Fool is long January 2021 $60 calls on Walt Disney and short October 2019 $125 calls on Walt Disney. The Motley Fool has a disclosure policy.