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Is Netflix Still a ‘Strong Buy’?

After Netflix, Inc. (NFLX) reported its Q2 2019 earnings yesterday, the stock plummeted by as much as 13% to $314 in late trading. The company saw a shocking loss of 130,000 U.S. customers likely as a result of a weaker content lineup and price increases.

With share prices dropping 5% over the last five days, investors have cause for concern. However, some analysts maintain that even after disappointing Q2 results, Netflix is still a ‘Strong Buy’ as this decline is only temporary.

Should investors listen to the analysts and hold on to NFLX shares?

A Weak Q2      

Q2 2019 represents the weakest quarter since the company split its DVD-by-mail and streaming segments of its business in 2011.

Subscriber growth was much slower than anticipated. NFLX only added 2.7 million new subscribers, about half of what management originally expected. Profits from the DVD segment were $46 million, 13% less than the year-ago period. Free cash flow dropped from -$559 million in Q2 2018 to -$594 million.   

However, the company’s fundamentals looked much more promising. Revenue reached $5 billion, up 26% year-over-year. Q2 operating income also jumped 53% year-over-year.

Management highlighted the fact that they believe the long-term trend is still positive. “If we look at the trailing 12 months, we grew our member base by over 27 million members. If you take that forward to where we think we'll be at the end of Q3, we think it will be, on a trailing 12-months basis, over 28 million members. So we're really playing for the sustained increase in growth in our membership over time and there be some quarter-by-quarter choppiness along the way based on things like seasonality and content slate and so forth,” said VP of Finance and Investor Relations, Spencer Wang.

Investors Have Reason for Concern

Netflix’s strategy up to this point has been to spend more on programming despite lower profits. In Q2, it spent over $3 billion on programming alone as well as an additional $600 million in marketing costs. So long as its customer base continued to grow, investors were able to look past heavy spending. Now that this growth has slowed, investors are concerned about its price points and the company’s ability to reach the domestic market. However, management predicts it will be able to increase its access to U.S. customers from 60 million to 90 million.

NFLX also failed to meet its goal for new international subscribers. Original estimates had its international customer base growing by 4.7 million, but the company only saw an increase of 2.8 million. Without strong overseas growth, investors are worried that Netflix won’t be able to justify its steep valuation.

Where does Netflix go From Here?  

In its Q3 guidance, management expects paid U.S. memberships to grow at a more typical rate. They are also hoping to see 7 million global paid net subscriber additions, up from 6 million in Q3 2018. Revenue is expected to increase by 31% to over $5 billion, driving GAAP earnings to reach $10.40 per diluted share.

For the fiscal year, the company is predicting free cash flow consumption of $3.5 billion. It hopes that a wider operating margin and stronger customer acquisition will improve this figure by 2020.

What are Analysts Saying?

The Q2 results haven’t shaken analyst Jeffrey Wlodarczak’s confidence in Netflix. In fact, he reiterated his Buy rating and raised his price target from $500 to $515 yesterday, indicating upside potential of 42%. He warns investors not to overreact to slowed subscriber growth. “A stronger slate and disappearance of a price hike related churn in Q3 are expected to generate a rebound in subscriber growth for Netflix during the back half of 2019,” he added.

Just today, five-star analyst, Scott Devitt, maintained his Buy rating and $400 price target. “We believe explanations for the current quarter miss appear reasonable, though with a likely louder market narrative around competition leading up to the November 12th Disney+ launch in the U.S., Netflix shares may be range bound until the next meaningful catalyst, 3Q earnings. At that time, Netflix will have to prove, as it has done many times, that its value proposition remains one of the best on the net,” he said. The analyst has a 74% success rate as well as a 21% average return per rating.    

Another top analyst, Michael Olson, said today that improved subscriber addition trends and a stronger content lineup are on the way. He added, “Despite an onslaught of new streaming services, we expect Netflix to continue to capture a significant portion of traditional content dollars as they migrate to streaming.” The analyst reiterated his Buy rating and $440 price target, suggesting upside potential of 21%.

The Verdict

Despite a lackluster second quarter, the Street remains optimistic that this is just a temporary setback. The stock boasts a ‘Strong Buy’ analyst consensus and average price target of $413, suggesting 14% upside.