The movie, television-series and documentary streaming giant, Netflix, reported fiscal second quarter results which missed profit estimates but beat revenue forecasts. The company also confirmed speculation of its foray into gaming as it hopes to capitalize on its vast library of intellectual property.
Revenue rose 19% year over year to $7.3 billion, with revenue growth this past quarter coming from an 11% increase in average paid streaming memberships and 8% growth in average revenue per membership (ARM). ARM rose 4%, excluding a positive foreign exchange impact of $277 million.
Global paid net subscriber additions came in at a higher-than-expected 1.54 million, however it lost 400k customers in the United States and Canada. The Asia-Pacific region represented about two-thirds of global paid net adds in the quarter, with the company finishing the quarter with over 209 million paid memberships. Expectations for subscriber adds was low given that COVID-19 had created lumpiness in membership growth. Netflix experienced higher growth in 2020 due to lockdowns and slower growth this year as vaccines were rolled-out and economies opened up. Netflix said it anticipates 3.5 million net adds for its third quarter, while investors were anticipating 5.46 million.
The company is facing tough year-over-year comparisons. Last year, in the midst of the pandemic, consumers spent much more time online and in need of entertainment. This was evident in second quarter engagement levels being down compared to last year, however, this number was still up 17% compared with the second quarter of 2019. Additionally, user retention continued to be strong and was better than pre-pandemic levels.
Operating income rose 36% year over year to $1.8 billion, and operating margins expanded to 25.2%. Both revenue and operating margins have increased consistently over time, with Netflix reinvesting the proceeds into the business. This has seen operating profit rise dramatically from around $100 million per quarter in 2016 to nearly $2 billion per quarter so far in 2021. Earnings per share (EPS) for Q2 was up 87% to $2.97.
Netflix has spent $8 billion in cash on content in the first half of this year, as much as what some competitors plan to spend over the entire year, making it very difficult to compete with. The company will expand its content offering to include podcasts which it hopes will reduce churn and capture new users. This is a positive development and may support adverts to diversify the company’s one-dimensional subscription revenue stream. Netflix has famously avoided ads in its video streaming business. Over the past decade, podcasts have seen a steady rise in popularity. According to Edison Research, 78% of Americans are now familiar with the term “podcasting” and more than 5 in 10 have listened to a podcast themselves.
As a result, free cash flow (FCF) is fairly constrained, coming in at -$175 million vs. $899 million in the same period a year ago. FCF last year benefited from COVID-related production shutdowns. However the company expects full year 2021 free cash flow to be break-even.
Whilst Netflix is an innovator, moving into the gaming arena is a concern to investors. Only Sony, Microsoft, Google and Amazon have made any progress in streaming games. Sony had to make two acquisitions and spent billions doing so - and the other three players are the world’s largest cloud-based services companies with gaming experience. In terms of more sophisticated gaming, Netflix faces major technological hurdles. The majority of video games are only available on dedicated consoles (like a playstation or xbox) or on personal computers (PC’s). So, Netflix would have to develop a way to stream games seamlessly online. And if they do that, they will also have to figure out how to provide users with a game controller that will work across multiple different platforms - which competitors would want to prevent. Also, historically, successful video-games based on television shows have been extremely limited. Iconic film franchises have made some successful video games like Harry Potter, Star Wars and Lord of the Rings, but again, this list is also very limited. Does Netflix have enough blockbuster hits to do this?
Initially, Netflix said it would focus on mobile games, and that they would come at no additional cost. In terms of mobile games, over 40,000 new mobile games are produced each year. Few of the 3.5 billion mobile gamers worldwide are likely to buy a Netflix subscription for the 2-3 potential games they release annually. The strategy is that it will help fans immerse themselves in the universe of the shows they love, whilst new seasons (or movies in a franchise) are under development. But game production comes at a significant cost. And the hiring spree they’ve embarked upon to bolster this division, poaching from Apple, Facebook and Electronic Arts, includes resumes with spotty track records when it comes to actual game releases.
Netflix is a great business, and reinvesting to grow and expand has served them and their shareholders well thus far. I am however concerned they are moving too far from their core competency, which is video design and development. But maybe the business has grown to a stage where it needs to stretch its legs. To build podcasts, video games, merchandise and theme parks like Disney and the other entertainment giants holding major IP. Competition has also seen their business model come under pressure in recent quarters. However, with their larger content budget and pipeline it will be difficult to supplant them as the leading streaming service - at least for the time being.