This quarter showed continued progress on cost cutting, growth, and planting seeds for potential future growth. Underlying operating expenses excluding restructuring and impairment charges, supplier settlements, and the accrual of a one-time $75 million payment to DISH to settle a patent dispute fell to $407 million in the quarter. That is down from a peak of $697 million five quarters earlier. That is solid progress and there are more cuts to come.
From a long-term investor’s perspective, Spotify’s first-quarter report was really strong. I’m not talking about the backward-looking financial metrics—gross margin is still ~25%, operating expenses are still too high, and operating income is still negative. But a snapshot in time is far less important than where the puck is going. And on the margin, it feels like we’re on the cusp of something really great—accelerating user growth, improving gross margins, improving operating expense leverage, and with any luck, a long overdue price increase in major markets that comes with a more favorable revenue split with the labels. With a multiyear perspective in mind, here’s what I found most important.
I posted some mostly qualitative thoughts about Netflix after its first-quarter results (Netflix: To the Victor Go the Spoils). But however competitively advantaged Netflix is, however long their growth runway may be, whatever their long-term margin and cash flow profile might look like, it can all become irrelevant if our expectations are already reflected in the stock. If that’s the case, the company can perform as well as we expect but we still might only earn average returns over time. Or if even higher expectations than ours are already baked in, the company could meet our expectations but the stock can still underperform. That’s the disaster we’re trying to avoid.
As for the quarter itself, there wasn’t much surprising. Revenue was as expected, margins were a bit better, and free cash flow of $2.1 billion is starting to ramp. I could go through all the metrics for these 90 days but frankly, whether revenue growth or margins came in 100 bps better or worse than expected or quarterly EPS beat or missed is really not that relevant for long-term shareholders. What is relevant are any new data points or learnings that provide greater clarity or confidence into the extent to which Netflix can live up to its long-term potential as the global SVOD leader and how that will translate into free cash flow over time. From that perspective, here is what I found important.
Last week, Carvana announced an exchange offer to its existing noteholders. I’ll get to the details in a bit, but probably more interesting was management’s release of preliminary first-quarter results in conjunction with the offer.
Preliminary first-quarter results, specifically regarding SG&A and adjusted EBITDA, meaningfully exceeded expectations. This was roughly consistent with the thesis I outlined in Carvana: Groupthink, although first-quarter adjusted EBITDA will beat my prior estimate as well.
I was about to write that Carvana is a super controversial stock, but that implies it’s hotly debated among the bulls and bears. I don’t really see that. Most seem to assume Carvana is going to declare bankruptcy shortly and any bulls that remain are in hiding. When sentiment gets that one-sided, I think it’s worth taking a close look while trying to be objective. Because if sentiment happens to be plagued by groupthink, flawed analysis, or little analysis at all, and things end up ok, that’s how career-defining investments are possible. Or sentiment could turn out absolutely correct, even if a lot of it hasn’t been thoughtfully considered, leading to a total loss. Interested? Read on.
“Stock prices are the clearest and most reliable signal of the market’s expectations about a company’s future financial performance. The key to successful investing is to estimate the level of expected performance embedded in the current stock price and then assess the likelihood of a revision in expectations.” – Michael Mauboussin
It’s interesting to me how clear it was that Peloton was on this path towards cash flow breakeven yet the market refused to give it any credit until this quarter.
Netflix is getting harder to value. I don’t mean the process is more difficult than it used to be. I mean the range of upside outcomes is becoming wider. It has always been hard to be precise but that is getting even harder.
The headlines focused on Reed Hastings stepping down as co-CEO. That is understandable. Certainly, he is a business legend, having co-founded a DVD-by-mail startup, vanquished larger competitors, pivoted the business twice, first by pioneering into streaming and later into original content. Netflix now dominates the field with $32 billion of global streaming revenue from over 321 million global household users, including 231 million who are currently paying for it.