Is Netflix A Buy After This Latest Plot Twist?

Is Netflix A Buy After This Latest Plot Twist?
Reda Farran, CFA

over 1 year ago5 mins

  • Netflix returned to subscriber growth in the latest quarter, but it wants to shift investors’ attention away from customer numbers and toward other metrics.

  • The firm plans to increase revenue by introducing an ad-supported version of its streaming service in November and charging for password sharing next year.

  • Netflix is a less-attractive investment today considering its 60%-plus recovery from May’s lows and its relatively high P/E ratio.

Netflix returned to subscriber growth in the latest quarter, but it wants to shift investors’ attention away from customer numbers and toward other metrics.

The firm plans to increase revenue by introducing an ad-supported version of its streaming service in November and charging for password sharing next year.

Netflix is a less-attractive investment today considering its 60%-plus recovery from May’s lows and its relatively high P/E ratio.

Mentioned in story

What a year it’s been for Netflix. Back in April, the streaming giant announced it had lost viewers for the first time in a decade in a shocking update that sent its stock price down 35% in a single day. I wrote back then about whether the firm could turn things around and whether you might want to think about buying shares. So with the firm reporting a return to growth this week, it’s a good time to revisit that investment thesis.

What did Netflix report?

After losing subscribers during the first half of the year, Netflix added 2.4 million customers in the third quarter, growing in all regions of the world and exceeding its own projections as well as analysts’ forecasts of 1 million. That helped it push up its revenue and profit to both tidily beat analysts’ expectations too. Netflix also said it expects to add another 4.5 million customers this quarter, meaning the firm is on track to end 2022 with 227.5 million subscribers – or 2.6% more than it had at the end of last year. That’s not the rocket-ship growth it saw during the pandemic, but it’s impressive nonetheless – especially in light of all the pessimism this year.

Netflix forecasts an acceleration in customer additions this quarter. Source: Bloomberg.
Netflix forecasts an acceleration in customer additions this quarter. Source: Bloomberg.

How is Netflix turning things around?

1. Making money from people who use the service but don’t pay for it.

Netflix estimates that in addition to its 223 million paying subscribers, there are more than 100 million people who use the service without paying for it. It’s going to start monetizing those viewers early next year in two ways. First, it’ll crack down on password sharing. This goes hand in hand with a new “Profile Transfer” feature that makes it easier for password borrowers to transfer their Netflix profile into their own account. Result: more paid subscribers. Second, it’ll allow subscribers to create sub-accounts for their friends or family in exchange for an additional monthly fee. Result: more revenue.

2. Addressing price-driven customer cancellations.

Soaring costs for life’s necessities are pushing people to cut back on luxuries like streaming services – a decision that’s become even more crucial as streamers raise prices. Netflix’s answer to this is a lower-priced version of its service that has advertising, which it plans to launch in 12 countries next month. According to the firm, demand for the new service is strong and is expected to lower customer cancellations while bringing in new users. What’s more, at $7 a month, Netflix’s ad-supported service is competitively priced: it’s $3 a month lower than the ad-backed version of HBO Max and $1 less than the forthcoming Disney+ with commercials.

What Netflix’s different tiers will look like from next month. Source: Bloomberg.
What Netflix’s different tiers will look like from next month. Source: Bloomberg.

The firm said that it has already secured hundreds of advertisers and sold out most of its ad inventory for the new service ahead of its November launch. Selling ads will create an entirely new revenue stream for Netflix – at little to no cost. According to media analysis firm Ampere, Netflix will earn $5.5 billion in annual advertising income by 2027.

Netflix is projected to make $5.5 billion in ad revenue in 2027. Source: Ampere.
Netflix is projected to make $5.5 billion in ad revenue in 2027. Source: Ampere.

Is the number of subscribers the right number to focus on anymore?

While investors have long judged Netflix based on the number of subscribers it adds every quarter, the firm would rather be considered based on more traditional financial metrics like revenue and operating profit – especially as customer growth “matures” in its major markets. To that end, Netflix said it’ll no longer provide subscriber forecasts to investors.

On the revenue front, the new ad-supported service and password-sharing strategies are expected to play a big role. But the firm is also expanding into mobile gaming – for another potential new revenue stream. All in all, based on analysts’ forecasts, Netflix is expected to grow its revenue at a compound annual growth rate (CAGR) of 9% from 2021 to 2025. That’s a faster rate than your average US firm.

On the operating profit front, Netflix is expected to make $5 billion to $6 billion this year. And in a jab at its rivals, the firm said that its competitors are investing heavily to drive subscribers and engagement – and that they’re all losing money as a result, with combined 2022 operating losses well over $10 billion (Netflix’s estimate).

What does Netflix’s stock valuation look like now?

If subscriber numbers are becoming less relevant and investors should focus on operating profit, we should assess Netflix's valuation using its forward price-to-earnings (P/E) ratio. The firm is now worth 24.8x its forecasted profit over the next 12 months. That’s higher than the Nasdaq’s 19.6x and Disney’s 19.1x. The comparison with the latter is less relevant because its streaming service, Disney+, isn’t expected to be profitable until 2024, whereas Netflix is already profitable. Compared to the average firm in the Nasdaq, Netflix has a stronger growth outlook, better profit margins, and generates a higher return on equity. Put differently, Netflix’s stock deserves to trade at a higher P/E ratio than the Nasdaq and a ~25% premium looks fair.

What’s the conclusion here?

With the benefit of hindsight, you can see Netflix’s huge stock plunge after its first-quarter results was overdone and offered traders a good investment opportunity – the argument I made at the time. The firm has since returned to subscriber growth and its stock is up more than 60% from the low it hit back in May.

Netflix’s outlook is still favorable. See, with a potential economic recession on the horizon, many US firms could see their profits shrink. Netflix, in contrast, has many avenues to generate earnings growth in the near term: selling ads, monetizing those non-paying users, expanding into mobile gaming, hiking prices, and, if all else fails, buying back its own shares, which would lead to earnings-per-share (EPS) growth. The company’s forecasted to generate $2 billion worth of free cash flow next year, after all, or 1.7% of its market value. Put differently, the company can buy back 1.7% of its shares next year, and potentially every year (all else equal), which would increase EPS annually by a similar amount.

On the other hand, considering that Netflix’s stock trades at a 25% higher P/E than the Nasdaq, its stronger growth outlook is arguably already priced in. And that, combined with the stock’s 60%-plus recovery from May’s lows, means Netflix is a less attractive – but not necessarily bad – investment today.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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