Dueling Analysts Debate Netflix, Inc.'s Fourth Quarter

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Netflix (NASDAQ: NFLX) investors had a tough day this Wednesday. Share prices slid 2.4% lower at 10:45 a.m. Eastern time, though the streaming video giant's stock recovered to a less destructive 1.3% loss before the closing bell.

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The drop was a sharp reversal from Tuesday's action, when Netflix shares set fresh all-time highs thanks to bullish analyst previews of next week's fourth-quarter report. As it turns out, today's reversal was also powered by earnings previews -- of a more bearish flavor.

First, the bull

On Tuesday, analyst firm Raymond James raised its price target for Netflix shares from $220 to $260. The firm's "buy" rating is supported by four pillars that analyst Justin Patterson calls "underappreciated" even at these record-high prices:

  • Strong subscriber growth in international markets.
  • Expanding international profit margin.
  • The pricing power and domestic growth opportunity that comes with an impressive content catalog.
  • A growing competitive moat that separates Netflix from the likes of Hulu, Amazon.com's (NASDAQ: AMZN) Prime Videos, and YouTube Red.

It was no surprise to see Netflix shares rising on that rosy report. It's harder to see any obvious flaws in Patterson's reasoning. Netflix really is growing both its subscriber count and profit margin overseas. Here at home, none of the rival services can measure up to Netflix's combination of award-winning original content and user-friendly apps.

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Amazon just can't stop itself from trying to sell retail products such as full-priced pay-per-view downloads or Blu-ray disks when you're trying to enjoy your paid subscription to Prime Video. Hulu inserts advertising into your videos, even though you already paid for access to that content. So the moat between Netflix and the rest isn't getting any smaller, though Disney (NYSE: DIS) just might change that in 2019. That's a concern for later, though. We don't even know what Disney's new streaming platform will look like yet.

Then the bear

Wedbush Morgan analyst Michael Pachter has been pessimistic about Netflix since time immemorial, and he kept up that bearish outlook ahead of the fourth-quarter report as well"

"We expect Netflix to burn cash to fund content acquisition for many years, notwithstanding the fact that it has increased price three times while cash bun continues to grow," said Pachter in a note prepared for Morningstar. "We don't expect Netflix to become meaningfully profitable on a cash basis for several years, and we don't expect positive free cash flow for the remainder of this decade.

"We think that Netflix is destined to be a cash-burning, high-growth company until it changes its strategy and accepts its fate as a highly profitable, slow-growth company."

Based on that analysis, Pachter's price target for Netflix shares remains at $93 -- more than 50% below current prices.

Like Patterson, Michael Pachter isn't wrong. Netflix is indeed going to burn cash for the foreseeable future, using new debt and maybe even stock sales to raise more funds along the way. Free cash flow has been negative since the heavy push into original content creation started, and it should remain that way until the content bets start to pay off.

Yes, Netflix is a "cash-burning, high-growth company" today, and it will stay that way for a while. The international growth effort is only getting started, and both domestic and foreign growth will depend on additional content spend over the next few years.

Pachter and Patterson simply disagree on whether that's a bad thing, and I tend to side with the bullish analysis.

In my view, it makes perfect sense to stake out a defensible lead as streaming video markets hit the mainstream around the world. Do what it takes to build an unassailable long-term moat now, and then switch gears and reap the cash-flow rewards later. That's the philosophy at work here, and Pachter just doesn't think it will work.

Who's right? Who's wrong?

Next week's earnings report should give us more clues, of course. Management's official forecast calls for 1.25 million net new domestic subscribers in the fourth quarter, alongside 5.05 million new international customers. Reaching these goals would result in a global customer count of 115.55 million members and $3.27 billion in top-line revenue.

International operations should deliver positive "contribution profits" -- Netflix's preferred term for each segment's operating profits -- from here on out, even as the negative free cash flows continue.

These guidance targets account for price increases on most domestic and some international plans during the third and fourth quarters. The assumption is that higher prices should put a lid on subscriber growth, which is why the additions in the fourth quarter of 2017 should be lower than the previous year's.

If that hypothesis turns out to be too optimistic, growth rates will have turned out slower than expected. On the other hand, too-gloomy assumptions would lead to a rosy report. So much depends on these price changes.

As I said, I think both Pachter and Patterson are more right than wrong -- but Patterson seems to have a better grasp on how the moving parts of Netflix's financial machinery add up to value creation in the long run.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Anders Bylund owns shares of Amazon, Netflix, and Walt Disney. The Motley Fool owns shares of and recommends Amazon, Netflix, and Walt Disney. The Motley Fool has a disclosure policy.