Have Netflix’s Calamitous Results Made It A Good Buy?

Have Netflix’s Calamitous Results Made It A Good Buy?
Reda Farran, CFA

almost 2 years ago5 mins

  • Netflix is losing subscribers due to competition, customer cancellations, and password sharing – but it’s got plans to mitigate some of that.

  • Its valuation looks cheap relative to its own history and the wider stock market, with its P/E in line with low-growth companies despite having growth optionality.

  • But there are risks, including further customer cancellations, subscribers downgrading to cheaper plans with ads, and the streaming business model not being highly profitable.

Netflix is losing subscribers due to competition, customer cancellations, and password sharing – but it’s got plans to mitigate some of that.

Its valuation looks cheap relative to its own history and the wider stock market, with its P/E in line with low-growth companies despite having growth optionality.

But there are risks, including further customer cancellations, subscribers downgrading to cheaper plans with ads, and the streaming business model not being highly profitable.

Mentioned in story

Netflix’s subscriber growth was bound to slow after it added a heap of users in 2020, but the streaming giant actually lost viewers for the first time in a decade last quarter. That led the percentage of analyst buy ratings on the firm’s stock to plummet to an eight-year low, and Bill Ackman’s Pershing Square to sell the more than $1 billion stake it amassed just a few months ago. But with Netflix’s share price now down over 60% this year, their skepticism might be your window of opportunity…

Why are Netflix’s subscriber numbers falling?

1. Password sharing

Netflix estimates that in addition to its 222 million paying subscribers, there are more than 100 million people using the service without paying for it. The company is now exploring ways to monetize those viewers by, for example, cracking down on password sharing, in turn forcing some of them to sign up. Or it may ask subscribers who share their account details to pay more – something it’s already experimenting with in Chile, Costa Rica, and Peru.

So password sharing might’ve been a reason for slowing subscriber growth in the past, but it could actually be a growth opportunity for the firm in the future. If Netflix can, say, sign up just a quarter of that 100 million, it could increase its user count by 11%.

2. More competition

This has always been a concern, and always will be. According to one report, media firms are expected to spend $230 billion or more on content this year as the streaming wars intensify.

The only bright spot I can point to here is that Netflix remains well ahead of most of its competitors outside the US, thanks to its huge investments in foreign programming. The South Korean hit “Squid Game”, for example, helped Netflix add 1 million subscribers in Asia-Pacific last quarter – the only region where the firm managed to grow its user count.

Asia-Pacific was the only region where Netflix added subscribers last quarter. Source: Bloomberg
Asia-Pacific was the only region where Netflix added subscribers last quarter. Source: Bloomberg

3. Customer cancellations

Soaring costs for life’s necessities are pushing people to cut back on luxuries like streaming services – a decision that’s become all the more crucial as streamers raise prices. But if you believe that inflation will eventually come down and that wages will catch up, restoring consumers’ spending power, then this may just be a temporary setback.

In the meantime, Netflix is working on a potential solution: it’s planning to create a lower-priced version of its service that has advertising. That could help reduce price-driven cancellations, while attracting new users and creating a new revenue stream from ads. But while HBO Max – which has rolled out a similar strategy – hasn’t seen its subscribers of the pricier ad-free plans downgrade to the cheaper option (yet), that’s still a risk for Netflix.

4. Suspension of its services in Russia

This move resulted in a loss of 700,000 subscribers, but it’s just a one-off event that shouldn’t be cause for concern. And in the grand scheme of things, the number of Russian subscribers lost relative to the 222 million global base is barely a rounding error.

How has all this impacted Netflix’s valuation?

Netflix is now worth 3x its forecasted sales over the next 12 months – the lowest it’s been since early 2015, and way below its five-year average of 7x.

Netflix’s P/S ratio is the lowest it has been in more than seven years. Source: Bloomberg
Netflix’s P/S ratio is the lowest it has been in more than seven years. Source: Bloomberg

Now, Netflix’s potential for growth is weaker than it’s been at any point over the past five years, so it’s only rational that its stock should trade at a lower price-to-sales (P/S) multiple. But even then, the 57% discount it’s currently trading at is arguably starting to look a little unfair. What’s more, Netflix’s P/S is now 30% lower than the Nasdaq 100 index’s 4.3x. That’s the first time since January 2013 that Netflix’s P/S has traded at a discount to the Nasdaq. Put simply, Netflix is at a deep discount to both its own history and to the wider stock market.

But as Netflix’s subscriber and sales growth slow, operating leverage and the firm’s ability to generate profit arguably become more important than sales.

So perhaps we should use the price-to-earnings (P/E) ratio rather than price-to-sales. Netflix is now worth 19.4x its forecasted profit over the next 12 months – in line with Home Depot, another pandemic-winner stock. That’s important because Netflix’s valuation is neck and neck with a low-growth company, even though the streamer has many potential avenues for growth – from converting those 100 million nonpayers, from selling ads (an entirely new revenue stream), and from expanding into mobile gaming.

If all else fails, Netflix might see its depressed stock price as an opportunity to buy back its shares, which would lead to earnings-per-share (EPS) growth. The company’s free cash flow amounted to $802 million last quarter. On an annualized basis, that represents 3.2% of the company’s market value. Put differently, the company can buy back 3.2% of its shares every year (all else equal), which would increase EPS annually by a similar amount.

So should you invest in Netflix?

There’s definitely a strong case for it. If you buy Netflix's stock today, you're basically snapping it up at a valuation multiple fit for a low-growth company. That means you’re getting a free “call option” on any future growth the company can generate. And as for Netflix’s subscriber loss last quarter, all of the reasons are either temporary setbacks or even potential growth opportunities.

That is, with one exception. Increasing competition is a genuine concern, and it’s arguably the biggest risk – beyond customers canceling their subscriptions, or downgrading to cheaper plans – with investing in Netflix. With competition intensifying, streamers are having to constantly spend on new content to grab viewers – especially given that popular shows can be binged in a single night. This huge yet necessary spending every year raises questions about the business model as a whole, and whether any streamer can be highly profitable.

A good analogy is the telco industry. The biggest US telecoms groups have to invest heavily every year to offer the best service, while also keeping prices low because they’re effectively selling the same product as their competitors. And while telcos make money, their profitability is nowhere near the eye-popping levels you find in some parts of the tech industry.

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