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Strong Growth at Netflix May Not Be Enough

Adam Levine-Weinberg, The Motley Fool

Earlier this week, Netflix (NASDAQ: NFLX) reported another quarter of impressive revenue growth. Revenue and subscriber gains both modestly outpaced the guidance that management provided back in January.

That said, it is clear that Netflix's growth rate is finally slowing after years of rapid expansion. Rising competition from Walt Disney (NYSE: DIS) and others -- particularly in the U.S. -- could put further pressure on its growth in the years ahead. With free cash flow still deep in negative territory, it's not clear if Netflix is growing enough to justify its massive $157 billion market cap.

Growth continued last quarter

In the first quarter of 2019, Netflix added a record 9.6 million new paid streaming subscribers globally. This boosted its global paid streaming subscriber count to 148.86 million by the end of the quarter, up 25.2% year over year. Netflix's guidance had called for adding 8.9 million paid streaming subscribers.

Revenue rose at a somewhat slower rate last quarter, due to currency headwinds and the steady decline of Netflix's legacy DVD-by-mail business. Total revenue increased 22.2% to $4.52 billion, representing a stark deceleration from the 40.4% revenue gain logged in Q1 2018. Still, this was slightly better than Netflix's revenue forecast of $4.49 billion.

Netflix's growth is increasingly tilting toward international markets. Netflix grew its domestic paid streaming subscriber count by 1.74 million last quarter, whereas it added 7.86 million paid subscribers outside the U.S. At the end of the quarter, Netflix had just 9.3% more paid domestic streaming subscribers than it had a year earlier, whereas its paid subscriber count was 38.9% higher in international markets.

A Netflix content screen featuring the Daredevil series

Netflix's growth is slowing in the U.S. due in part to market saturation. Image source: Netflix.

From a profitability perspective, Netflix still has a lot of work to do. Operating income ticked up less than 3% year over year last quarter, to $459 million. Moreover, the company burned $460 million of cash in the first quarter and expects to burn about $3.5 billion this year.

The second-quarter guidance is more troubling

Netflix's profitability tends to be volatile from quarter to quarter, but it has clearly been on an upward trajectory over the past few years. Thus, investors have good reason to believe that the company can expand its profit margin significantly in the coming years -- assuming growth remains robust.

Unfortunately, Netflix expects subscriber growth to decelerate this quarter. Its forecast calls for 5 million paid streaming subscriber additions: 0.3 million in the U.S. and 4.7 million abroad. For comparison, it added 0.87 million domestic paid streaming subscribers and 4.58 million international paid subscribers in the second quarter of 2018. Notably, those year-ago results fell well short of investors' expectations at the time.

To be fair, the second quarter tends to be seasonally weak. Additionally, Netflix is in the middle of implementing a price increase in the U.S. and several other markets, which has increased churn (i.e., subscriber cancellations). Historically, it's found that the uptick in churn following a price increase dies down after a while.

Still, Netflix is nearing saturation in the U.S. market, so its growth probably would be slowing anyway. Furthermore, the recent price increase is the most significant one it has attempted in recent years, so customers may react differently than they have to previous price changes.

Disney competition could hurt -- but not the way you might think

Slowing growth for Netflix should be somewhat concerning for investors, because the streaming video pioneer is about to face a surge in competition. Most notably, Disney recently unveiled its long-awaited Disney+ streaming service, which will launch in the U.S. in November.

Netflix bulls believe that Disney+ isn't likely to steal many customers from Netflix, despite Disney's strong brand and its big library of popular movies and TV shows -- and they have a point. Netflix will continue to have far more content than Disney+, including lots of edgy adult-oriented shows, whereas Disney+ is squarely focused on kids' and family content. Thus, Disney+ may be more suitable as a complement to Netflix than as a replacement.

However, even if Disney+ doesn't cause many people to dump their Netflix subscriptions, it could make them more resistant to price increases. Disney+ will cost just $6.99 per month, or $69.99 annually. That compares to $12.99 a month for Netflix's most popular plan.

With Netflix already charging roughly twice as much as Disney+, additional big price increases could cause some subscribers to start to wonder if they are overpaying for Netflix. The service can certainly command a premium, but not an unlimited premium. With price increases (rather than subscriber growth) becoming increasingly critical to Netflix's domestic revenue growth, a loss of pricing power could disrupt the company's growth trajectory.

How much growth is left?

Of course, Netflix can still expect plenty of growth from its international markets for now. But some of its older international markets are only a few years behind the U.S. in terms of maturity, so international subscriber growth may start to moderate in the next few years.

In the long run, it's virtually inevitable that Netflix's revenue will grow to be much larger than it is today. But shareholders are counting on truly extraordinary growth, considering that the company is still years away from breakeven free cash flow, despite projected 2019 revenue of more than $20 billion. The recent earnings report didn't offer much evidence one way or the other about whether Netflix will get the level of growth it needs to justify its lofty valuation.

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Adam Levine-Weinberg owns shares of Walt Disney. The Motley Fool owns shares of and recommends Netflix and Walt Disney. The Motley Fool has a disclosure policy.