Netflix (NFLX) posted a mixed third quarter, as subscriber growth came in slightly below guidance and our expectations, but revenue was just ahead of our projections. The firm burned US$551 million during the quarter, down from a loss of US$859 million a year ago. However, management maintained its 2019 free cash flow loss target of US$3.5 billion, implying a cash burn of US$1.9 billion in the fourth quarter which would be a single quarter record. While continuing to insist the cash burn will decrease in 2020, management admitted that Netflix will move “slowly” toward positive free cash flow. We are retaining our narrow moat rating and fair value estimate of US$135.
Netflix’s streaming subscriber base continues to grow, ending the quarter at more than 158 million global paid subscribers, up from 130 million a year ago. Subscriber growth in the U.S. was weaker than expected (0.52 million net additions versus guidance of 0.80 million) while the international segment came in just ahead of guidance (6.3 million net adds versus guidance of 6.2 million).
The continued slowdown in U.S. growth reinforces our belief that adding and retaining the marginal subscriber is becoming increasingly challenging for Netflix. Monthly revenue per paid U.S. member increased 16% versus a year ago to US$13.32, due largely to recent price increases, which have been phased in completely in the U.S. Management noted that customer disconnects remained elevated during the quarter, reinforcing our hypothesis of some price sensitivity among marginal subscribers, with a less price-sensitive core user base. However, we still expect that coming competition with lower-price plans will test the price sensitivity for these core users--both Apple TV+ and Disney+ will launch in November, with HBO Max and Peacock from NBCUniversal following next spring. Feeding these services has also driven up content costs, as management indicated that the cost to develop premium content has increased about 30% over the past year.
For the international streaming segment, revenue of US$2.8 billion beat our estimate, as monthly revenue per paid member increased 5% year over year to US$9.73 without currency adjustments. Despite the growth, we still expect monthly revenue per international paid member to decline slightly over the next few years as the company attempts to spark growth in emerging markets with lower-priced plans.
Total segment contribution margin of 30.4% improved by 640 basis points year over year, leading to an operating margin of 18.7%, up 440 basis points from the same period last year, due in part to lower relative marketing spending and content cost amortization. Despite the strong operating margin improvement, management held fast to its guidance of 13% operating margin for 2019, implying increased content amortization, with a range of movies and shows set to release, and higher marketing spending in the fourth quarter.
Management touted that the slate in the third quarter was strong led by the final season of Orange is the New Black. As we noted last quarter, a relatively modest slate was blamed for the weak subscriber growth. However, this theory implies that the firm will need to have a strong slate every quarter to attract and retain subscribers. As the competition ramps original content spending and adds content from legacy movie and television libraries, standing out will likely prove increasingly difficult. Netflix’s lack of multiple release windows and this flood of content will continue to hamper discovery, leading to more shows and movies being lost in the ether of the Netflix algorithm. We think that the firm will either need to ramp up marketing spending or change the way that new content is added to the platform to alleviate the discovery issue.
We think the company’s decision to start providing subscribers by region in January 2020 is a welcome bit of transparency on the increasingly important subscribers outside the U.S. However, the reasoning to no longer breakout operating expenses and margins by segment due to the increase in global original content appears shortsighted. While some the firm’s original content is truly watched globally, we believe much of the newer local language content will have a limited audience outside of the countries or regions it was created for. Additionally, Netflix also incurs other expenses including marketing which we expect to grow as more content gets added to the platform and discoverability becomes increasingly difficult. Also, we think the move to only focus on global operating margin will obscure the slower pace of expansion for the international operating margin, a key tenet for some Netflix bulls.
