Netflix and United Continental Earnings -- What Lies Ahead for Investors?

By Chris Hill Markets Fool.com

On this episode ofMarket Foolery, Chris Hill is joined by Motley Fool analysts Jim Mueller and David Kretzmann as theydiscuss two widely-held stocks that delivered earnings last week:Netflix(NASDAQ: NFLX), and United Continental(NYSE: UAL).

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The streaming video giant had a fair first quarter, but new subscriber numbers lagged expectations, and they'll be issuing more debt to pay for all that new and original content. Meanwhile, the airline beat expectations, but with the controversy surrounding its treatment of a passenger, the markets wait to see whether public outrage translates into lower ticket revenue or profits.

And finally, the team dips into the mailbag to answer a listener question regarding the value of owning a sports team or stadium naming rights.

A full transcript follows the video.

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This video was recorded on April 18, 2017.

Chris Hill: It'sTuesday, April 18. Welcome to Market Foolery. I'm Chris Hill. Joining me in studio today, fromSupernova, David Kretzmann,and from Stock Advisor and Motley Fool Options, Jim Mueller. Happy tax day, gentlemen. Everybodygot their taxes paid up? Based on your reaction, David, I'm thinking ...[laughs]

David Kretzmann: No,I think I did, butthere's something about tax day ...

Jim Mueller: I filed mine a month and a half ago.

Hill: Jim isthe responsible adult in the room.

Kretzmann: Weneed to be more like Jim.

Mueller: I do it early when I get a refund.I wait until the last minutewhen I have to pay taxes.

Hill: Smart, very smart. We're going to dip into the Foolmailbag, but Earnings-palooza isunder way, so we're going to start withNetflix. First-quarter profits came inhigher than expected, but subscriber growth,a little bit lower than projected,and there's a bunch of things we can get into here. But Jim,I'll start with you,then David. What's your headline for this quarter?

Mueller: Theheadline for this quarter, I think, is they'regoing to be raising more debt. Whenthey reported in theend of last year,earlier this year, theyprojected they're going to spend $2 billion in free cash flow. Negative-$2 billion free cash flow. That'sbecause they're still buying a lot of content to run thatvirtuous cycle. More members, more money,more good content, more members, and so on. As long as that works, they'll be fine. They'reprofitable. Their operating profitcame in really nice at 9.7%, higher than the 7% target they have for the year. This isthe first year where management is actually targeting and actually saying, "OK, we'regoing to start becoming profitable. We've been running for so long,we're going to become profitable." But, they were saying7% target for the year,so they're going to ramp upspending a little bit in the second quarter to bring that back down, from 9.7% back to the7% target. But it's free cash flow. Companies are in business to generate cash. If you're not generating cash, you're going to have to raise cash somehow, which means they're going to be raising more debt. A line from the release letter,that's what they call it, dear shareholders, they --

Hill: That's so quaint.

Mueller: Yeah.[laughs] They think theirleverage ratio is just fine.

Hill: I'm sorry, leverage ratio?

Mueller: No,they actually call it debt to total cap. And it took me a while. I thought for a momentthey meant debt-to-capital, which is a common ratio. Debt to total capital invested in the business, that's debt andshareholder equity. No,what they're talking about is debt to market cap. That set me back. They're well under 10%compared to peers that are at 30%, 70%, in that range. And that's true.Time Warner, 31% debt to market cap. But Netflix has a debt to capital ratio of over 50%. It's about 53%.

Kretzmann: You'retalking about the first definition you mentioned?

Mueller: Yeah, debt to invested capital. They're about53% while Time Warnersits at 48%. So they can say, "We can leverageup because Time Warner is leveraged up." But it makes me a little nervous, really.

Hill:David,what's your headline?

Kretzmann: Similar to Jim's,Netflix is reiterating that they will be in investment mode for years to come. Like Jim mentioned,in the letter, they said, "Yeah,free cash flow is negative,and it will be negative for years to come."

Hill: Many years.

Kretzmann:Yeah, many years.I don't know if that was something Wall Street wasnecessarily expecting.I think people would hope that the free cash flow wouldeventually become positive, sooner rather than later. But Netflix right now,this year, they're spending $6 billionproducing original content. And that number will continue to tick up for theforeseeable future.And the numbers that Jim mentioned,the numbers that Netflix highlightedin the letter, right now, they have about 10% of their market cap is in debt, compared toLions GateorStarz--

Mueller: Actually,it's closer to 5%.

Kretzmann: OK. So, it's under 10%. Compared toDiscovery CommunicationsorTime Warner, yeah, Netflix has a lower amount of debtcompared to those companies. Butthose other companies are also producing positive free cash flow.I feel likemanagement is stretching their definitions a little bit to say, "No,it's totally OK, don't worry, we'llcontinue to bring on billions of dollars of debt,don't worry about it." It's like, you guys aren't producing positive free cash flow. Your burn rateis actually increasing.So really, it comes down tothe original content they're producing,is it good enough, quality enoughto bring in new subscribers,continue to keep that subscriber growthgoing, andretain existing subscribers? That is what it comes down to. I thinkmost people would say, yeah, theiroriginal content tends to be pretty good, it's aneffective investment. But there are a lot of risks with the cash flow situation there.

Hill: Theywent out of their way tohighlight the fact that --they have a deal with Adam Sandler -- is it over 500 million?

Mueller: Right.

Hill: "500 million hours of Adam Sandler movies have been watched by our customers."

Mueller: SinceThe Ridiculous 6,I think is the name of the film, which was first of their deal, andthey just extended the deal with Sandler, too.

Kretzmann: I haven't met anyone who thoughtthat was actually a good movie,but apparently a lot of people have watched it. And I did watch it.

Hill: My reaction was the same as you two in this moment, was,I just started laughing, I said, are you kidding me? Five hundred million hours worth ofAdam Sandler movies have been watched? Butthe more I thought about it, the more I think it wassmart of them to call that out,because one of the signals that sends to Wall Street,if you think about it, is, "We knowwhat our customers are watching. We know what they're watching. We knowwhat they want to watch. Andall you people who made fun of us when we struck the deal with Adam Sandlerin the first place,500 million hours watched. How do you like me now?"

Kretzmann: In the letter, theyalso highlighted a couple of movies or shows that flopped. One of them that they mentionedwas the sequel to Crouching Tiger, Hidden Dragon, wherethey said, this is one that didn't work out so well. So they are admitting that not everything they're producing is a hit. Going forward,when they're investing this amount of money, when they'reburning this amount of cash and raising that amount of debt, it really does sting for them to have content that doesn't resonate well with audiences.I think that'll be something to watch.

Mueller: I like to hear that, too. If everything is a massive success, then they might loosen their controls on what they decide to invest in. So I like to hear that something doesn't work out as golden as most of the stuff.

Kretzmann: They're paying attention to it. They're not just throwing money blindly. So it is good to see them focusing on that.

Hill: There was a point in time with Netflix where international growth was being watched closely, and the number of countries that they were in was a point of focus. Now,it seems like since we've run out of countriesfor them to actually go into,now the opportunity and the challenge for Netflix isgetting more subscribers in those countries. Jim,can you look at this stock and say, OK,even with everything we've already said about the free cash flow,even with the fact that this is kind of still a pricey stock,is there still an enormous opportunity overseas?Because it kind of seems like there is.

Mueller: Honestly,I think there is. Full disclosure,Netflix is my single largest position in my portfolio,and I've held shares since early 2007. So I have a nice basis on these shares. That might becoloring my viewpoint a little bit,because so much of my investments aretied up in this company. But having said that, I think the addressable market,which is what your question is about, Chris, is still quite large. So they'rerecently penetrated in the U.S. about 50% or so into all of the households in the U.S. David Wells,CFO, mentioned that in the call, that some of their earlier international markets, they didn'tname them, but probably Canada orLatin America, maybe,but I was thinking probably Canada, arereaching that level as well. That does demonstrate thatit can be popular enough,and they can figure out that combination of [phone rings] -- I don't know why my phone rings,I don't know why it's audible. Apologies. They do figure out, inEurope and Australia, inLatin America, in Canada, they have figured outthe mix of content,locally grown, international,from Hollywood and the U.S. orwhatever that brings in subscribers and keeps them coming. And they're still working on that in Africa and Asia and thecountries they launched in last year. But that launch last year was in 120, 130 countries, was mostly mobile launch. There are a bunch ofmobile broadband accounts in the world, something like 3 billion of these things. Ifthey can get the penetrationin that, there's still a very big opportunityfor the company.

Kretzmann: I thinkHBOnow has 128 millionsubscribers, and management says they expect Netflix to cross 100 millionstreaming subscribers this weekend. So there's still room for them to catch HBO,potentially, in the next couple years. And, from there, as Jim mentioned, it'sjust a matter of grabbing more subscribers there. Andmanagement really is focusing on creating that local content,whether it's Mexico, Brazil, France, you name it, and trying to find the rightproportion of local content, as well as the global content that'savailable in every country.I think another deal that willcontinue to really help Netflix is their deal withDisney. This year,Rogue One will be streaming on Netflix, andfuture Star Wars films will be streaming on Netflix,a lot of the Pixar and Disney animation movies arealready on there. I think that will help to continue to attract some new subscribers.

Mueller: Certainly here in the U.S. That deal with Disney the movie releases is U.S. and Canada only. So they might renegotiate to get the worldwide rights to those things. But playing off your comment on productions in Mexico, theirSpanish content is not justLatin America, but the entireSpanish-speaking worldacross the planet. Their international content, theirinternationally produced content, isplaying pretty well all around the world.

Hill: Jim,you were talking about mobile. Thatreminded me that last week, went withthe family up to New York City for a few days,took the train up, taking the train back on Friday,crowded train,one of those situations whereyou take any seat that's available, soI just letmy kids fend for themselves. It's like, "You're on your own! Dad needs to get a seat!" So I'm sitting next to this guy, and I get settled, and I plug in myearbuds and start listening to a podcast, and I close my eyes, and I lean back, and the train is moving along, and the guy next to me -- my eyes are closed -- I feel him shaking a little bit. And I thought to myself, "He'sprobably moving around in his seat,getting comfortable." And thenit happened again, and it happened a third time. SoI open my eyes and sit up. I'm hoping the guy's OK, but I'm also thinking, "DoI need to say something to this guy? Like, what's your problem?" And I open my eyes and look over, he'smoving around because he's shaking with laughterbecause he has his phone out, he'sstreaming Louis C.K.'s latestNetflix comedy special, and he issilently shaking with laughter at how funny it was. I was like, "You know,I can't begrudge the guy that."

Kretzmann: That's a good sign. Oneother thing I will quickly mention is Rick Vinera is our fellow Fool onTwitter-- he mentioned that Netflix now hasless than 4 million DVD-by-mail subscribers. Remember, Netflix used to do that.

Hill: Yes. Welike to call that the Quikster part of the business.

Kretzmann: [laughs] Right. That'sthe first time it's been below 4 millionsubscribers since the third quarter of 2005. So, 12 years. It goes to show, it would be riskier for Netflix to not be making those investments,because if Netflix had not made that transition to streaming or original content, the company would be far less relevant today. So they are paying a price for those investments,but it's probably a smart way to go.

Hill: Let's move on toUnited Continental Airlines. First-quarter profits came in higher than expected, andI don't know about you guys, but I almost don't care about this quarter.I know that technically, this quarter for United included theincident with the doctor getting dragged off the plane. But I am already looking forward to three months from now, to see ... isn't that really the big question that's on the mind ofcertainly anyone who focuses on the business media, and anyone who is investing? I think this is one of the most interestingquestions that's going to play out in the short term right now. How tangible is this outrage? There wasplenty of outrage online over the doctor being dragged off the plane andcoming back on the plane and being bloody and all that. Does that translate into a meaningful decline in United Continental's business?

Mueller: You're both looking at me.[laughs]

Hill: I'm looking at both of you. AndI don't know, I look at this and think, part of me -- andI don't own shares of this or any other airline, but we talked a little bit about this earlier, David, part of me is rooting for them to get a little bit of pain here.

Kretzmann: Yeah,they need to feel some sting, some pain after that.

Hill: Yeah. Butit also would not surprise me,given the way the airline industry runs as a whole, it would not surprise me if, three months from now, we were talking about, "Yep,it was another good quarter for United Continental."

Mueller: I don't think it's going to matter one bit, to tell you the truth. I was doing some readingbefore coming in the studio. There was anepisode of Freakonomics from last June called "Why Does Everyone Hate Flying?"The answer is probably because it has become like mass transit. The cost of a flight, all in, including everything --inflation, baggage fees, buying a meal, everything -- ishalf of what it was 30 years ago. The safety recordof airlines is tremendouslygood. The last two accidentswith major U.S. airlines, the last one wastheAsianaflightcoming into San Francisco -- three people died, and one of them was killedon the ground after being hit by an emergency vehicle. So only two passengers diedfrom the crash. Before that, it was 2001, some 12 years earlier, when there were 265 people killed on theAmerican Airlinesflight out of JFK. Now, for a while,people were thinking it was shot down, that one. In that 12-year span, 442,600 people were killed on U.S. roads. Mass transit is what airlines are. When you get that, you get low fares,which is very important for a lot of people,but you also get a lot of inconvenience and,occasionally, you get beaten up.[laughs]

Kretzmann: [laughs]That's what we learned a couple weeks ago.

Hill: Andalong those lines, a big part of the story with United was the wholereally shining a light on airlines overbooking. But once the statistic started to come to light,you find out that yes, technically,this still goes on. It goes on a lot less than it used to.

Mueller: That's true.

Hill: So I don't know. Again, I feel like nothing would shock me threemonths from now in terms of results, in part because one X-factor at play here is theUnited States Congress, which,it would not surprise me at all if they decided, "You knowwhat's going to make us look good?" Becausefew things have as low of an approval rating inAmerica as the United States Congress. "What's going to make us look good is haulingOscar Munoz, the CEO ofUnited Continental,in front of us at a hearing andbeating him up for a while."

Mueller: That'sprobably going to happen. But what I thinkwould be better for the industry,and for passengers, too,is if competitors started coming out with ways to mitigatea lot of this bad press that everybody is getting. It's not just United.United is in the crosshairs right now, but they all do this, and thecarriage of contracts, which is what the ticket is, allows them to doalmost anything they want to. But if they're smart, they're going to say, to differentiate themselves, "We don't do this."

Kretzmann: Wedon't beat you up.[laughs]

Mueller: I've heard the food is coming back to one of them, [Delta Air Lines], maybe,coming back to the economy class,and you don't have to buy. Your ticket is going to go up a little. But a lot of people grumble about having to buy the box of three-week-old bread or whatever.

Hill: I mentioned this toeach of you individually this morning. We've seen businesses inother industries do very well withloyalty programs. We see it, certainly, with food and beverage. Why don'tairlines go bigger into theloyalty programs?When I'm on a flight and theymake the obligatory announcements about, "If you want ourfrequent-flyer card, we'll give you 10,000 miles." Whydon't they just right out of the gateastonish everyone with "We'regoing to give you a 100,000 miles,"just to get you into that program? Togo back to Netflix for a second, one of themistakes I think investors make aboutNetflix is in thinking that video streaming is a zero-sum game. It's not like buying a car. When you go out to buy a car, one automaker is going to win your business,and all the others are going to lose. Whenit comes to video streaming, yeah, you'regoing to have anAmazonPrime account, you'regoing to have aHuluaccount, you're going to have a Netflix account. In terms of the airlines, I feel like if one of them gets smart andfigures out a way to lock people into some sort of loyalty program that rewards customers, they'regoing to be a big winner.

Kretzmann: I think you're describingSouthwest, at leastmore than any of the other major airlines in the U.S. AndSouthwest has been an incredible performernot just in airlines, but across theS&P 500. It's one of the best-performing, if not the best performing, over the last 30 years since it went public in the late '70s. Southwest has locked down that loyalty program.I have a Southwest card. I prefer to flySouthwest if they have a route between the cities I'm flying to. AndI think that's an important point, because for me,I lose track of United, Delta,American.It's like, I know I booked with them,I'm probably going to get delayed,I'll probably get some warm orange juice on the flight,it's not going to be a pleasant experience, but it will get mewhere I need to be,probably just a little bit later than I would like.

AndI actually had a friend who came up to me last week and said, "Did you see that video ofwhat happened on the Delta flight?" I was like, "Do you mean the United flight?" I don't think there's a whole lot of brand differentiationat the end of the day with some of those airlines.But I think Southwest has done a good job with thatloyalty program. One of the perks of that is,Southwest doesn't make their flights available onthird-party platforms likeExpediaorPriceline. People have to go to Southwest's site,and it reinforces the brand that way. Whenyou have a positive experience,I think you get a loyal customer base.

Mueller: AndI think therein lies the answer to your question, Chris, iscommoditization. Those airline milesthat can be transferred across airlines,you can get them from almost any credit card you want. They're so cheap,and they are no longer worth what they used to be worth.

Hill: FromBrooke McCoy: "Theplayoffs have started in the NHL and NBA. Most major arenas are named after a public company,and in some cases, public companies actually have ownership stakesin the teams themselves.MSGownsthe New York Knicksand the Rangers.Bell CanadaandRogersjointly owned the TorontoMaple Leafs,Raptors, Toronto FC, and so on. We hearall the time about how major-league sportsfranchises seem to do nothing but go up in value. Does a company having a stake in a team helpmake it a more attractive investment? And,as a shareholder, how much value does a company lending its name to a major arena really generate? Arepeople really opening checkingaccounts atTDbecause the Boston Bruinsand Celtics play there?I'm a longtime listener, I love your work. Thanks for everything."

Thank you forlistening, and thank you for a great question. Really, two questions there. Let'stake the first one. Acompany having a stake in a sports team,does that make it a more attractive investment?I don't know, MSG isone of those things that's just not a particularly well-run company, andcertainly the stock performance over the last five years has trailed the market, so David,I'm sort of tempted to say it depends.

Kretzmann: Yeah,it's never something I thought about,investing in a company and thinking it's more or less attractive because they have a stake in a sports team. It'snever actually crossed my mind. MaybeI should pay more attention to it? But in general, I don't think it's a hugedifferentiator with a company. I don't think it's very common for a public company to own a stake in a sports team.

Mueller: Not very common at all. MSG has owned Rangers, one site said from 1926 on to the present. ButI didn't even know that until I looked it up.

Hill: Butwhat about the second question,which is a company slapping its name on an arena. The way it's phrased is, "How much value does a company lending its name,"let's be clear -- they are not lending their name; they're paying for that right.

Kretzmann: Yeah,it's part of their marketing.

Hill: Yeah, it'spart of their marketing. To answer the question,I don't thinkpeople are opening checking account with TDjust because the Bruins and the Celtics play there. But maybe it works, because in addition to slapping their name on their arena,they presumably also get tickets, they get a luxury box or suite or something like that.

Mueller: Theexecutives might. I think it's the Carla's Diner'sLittle League sponsorship writ large.[laughs] Very large in some of these arenas. But you get freemention of your company name. It's always theVerizonCenter here in D.C. forbasketball and hockey, or theSunTrustPark in Cobb County.

Hill: Yeah,in Cobb County where the Atlanta Braves play. Although, asa Washington Nationals die-hard fan, our producer, Dan Boyd, referred to them, the Cobb County Braves.

Mueller: [laughs] Right. So you get mentioned that way,you get on-sitepromotion,and it's a way to say, "Hey, we'rein your community, we're paying attention to you guys." But other than that, and advertising and namerecognition,I don't think it's much.

Kretzmann: Yeah,it's really just a form of brand advertising. Withthat kind of advertising, likewith the Verizon Center in D.C., whichwill be renamedsometime next year,Verizon is stepping away from that deal, but there's really no way forVerizon to measure the return on investment there. How many peoplesigned up as a result of seeing Verizon on the side of the building? Compared tosomething like marketing onFacebookorGoogle, where you can measuretheclicks and the engagement. Slappingyour name on an arena,that's really just a form of brand advertising. Inmy own case, it's hard for me to think of a timewhere that was really effective for me as a consumer. Growing up, the Sacramento Kings, my beloved Kings, they played inArcoArena, but we still bought gas fromChevron. Itdidn't really mean anything. They renamed it toPower BalancePavilion,Sleep TrainArena. Nowit's theGolden 1Center at their new arena.

Mueller: Boy,that's a lot of corporate names.

Kretzmann: Itwent through a lot of names, yeah,they burn through it. But it's just a form of brand advertising.I question whether it's reallythe best place for a company to allocate their marketing dollars.Hence, that's why you generally see these big name brands that have millions to throw at this.

Hill: That's the thing. I think you want to look at,separate from the money that is being paid -- because I think it's a legitimate question,If you're looking at an investment and saying, "OK,how are they spending their money?" If Company X is doing a good job with their business, you tend to overlooksomething like that. On the flip side, this email question reminds me of an article that ourcolleagues Tim Hanson and Brian Richards wrote in 2006,because in 2006,the NBA Finals featuredthe Dallas Mavericks againstthe Miami Heat. And atthe time, the Dallas Mavericks played inthe American Airlines Center, and the Miami Heat played in theAmerican Airlines Arena.

Kretzmann: Hedging their bets, well done.

Hill: And as they pointed out in that article,American Airlines was staggeringly unprofitable, and spendingsomewhere in the neighborhood of $8 [million] to $10 million a year. That's asituation where if you are an American Airlinesemployee or shareholder, you're like, "Hey, folks,what are we doing here? Why are we spending this money whenwe could probably find a better use for $8 [million] to $10 million?"

Mueller: Acompany should really be able to measure its return on investment. David, your point aboutbeing able to measure clicks, orclickthroughs on direct-send emails,that's easy to measure, andget to your measure on investment. But how much really can you get, measure your radio spend or television spend, or your arena spend?

Kretzmann: Yeah,those are all their own bucket of brand advertising.

Mueller: I think it's just a way of keeping the name in consumer's minds.Coca-Colahas a hugeadvertising budget. Everyone in the world knows Coca-Cola because of that budget. How long would it take for that to disappear if theystopped advertising? Maybe that's what they're worried about.

Hill: I remember proposing, I think on this podcast a couple of years ago,I just think it would be interesting if Coca-Cola orPepsidecided, "For one month, we're not spending a dime. We're just going topocket the money. We're just going to put it aside."

Kretzmann: Wouldthe world stop spinning?

Hill: Theworld would not stop spinning, andpeople would still be buying and consuming those two beverages.

Mueller: I'll switch to Shasta.

Hill: [laughs] All right. Jim Mueller, David Kretzmann, thanks for being here, guys!

Kretzmann: Thanks, Chris!

Hill:As always, people on the programmay have interestsin the stocks they talk about,and The Motley Fool may have formal recommendationsfor or against,so don't buy or sell stocks basedsolely on what you hear. That'sgoing to do it for this edition ofMarket Foolery. The show is mixed by Dan Boyd.I'm Chris Hill. Thanks for listening. We'llsee you tomorrow!

Chris Hill owns shares of Amazon, Coca-Cola, and Walt Disney. David Kretzmann owns shares of Amazon, Discovery Communications, Facebook, Lions Gate Entertainment Class A, Lions Gate Entertainment Class B, Netflix, Priceline Group, Twitter, and Walt Disney. Jim Mueller, CFA owns shares of Amazon, Coca-Cola, Netflix, and Priceline Group. The Motley Fool owns shares of and recommends Amazon, Discovery Communications, Facebook, Lions Gate Entertainment Class A, Lions Gate Entertainment Class B, Netflix, PepsiCo, Priceline Group, Twitter, Verizon Communications, and Walt Disney. The Motley Fool recommends Chevron, Rogers Communications, and Time Warner. The Motley Fool has a disclosure policy.