Netflix: 2023 Will Be A Pivotal Year For Its Turnaround Story

Summary:

With the top priority of management being the re-acceleration of revenues, this will be a top down effort to revitalise the business, which should improve investor sentiment.
With the launch of the ad tier, management expects minimal negative effects in the form of migration between plans and incremental costs from the ad tier.
Paid sharing experience in Latin America is teaching management how the initiative can be rolled out globally.
Guidance for subscribers remains robust while financials disappoint due to higher expenses.
My 1-year target price for Netflix is $318, which implies an upside of 15% from current levels.

Netflix (NASDAQ:NFLX) does seem like an interesting idea for 2023 given just how brutal 2022 has been for it. The key issue for Netflix is that it needs to demonstrate the regeneration and reacceleration of revenues for the investment story to make sense. After having had the first mover advantage in streaming for some time, 2022 was the year when investors finally caught up to the fact that there are competitors coming after Netflix. This came in the form of slower growth and a loss in subscribers as bad news just kept coming for the company. That said, I think that the bad news has been priced in and if anything, there is an opportunity for investors looking for a turnaround story for Netflix. Although this could prove to take some time, 2023 will be a pivotal year for Netflix.

Investment thesis

For Netflix, this remains to be a show and tell story. Investors need to see results in order to believe that the new initiatives will bring incremental and accretive benefits to the company. With management’s top priority bring revenue re-acceleration, I think that we will see improvements being made in 2023 that will bring significant value add for the business in the long-term as it looks to find new growth drivers as a maturing business. The optimization of content spend is one way in which it can affect the business materially. The content spend that management finds most optimal is $17 billion, which is what management has been communicating for some time. However, to maximize the use of this content spend is key as each dollar needs to be productive in generating new views and subscribers for the company in order for it to remain relevant and grow. In addition, new initiatives like the ad tier and paid sharing initiatives looks to roll out and ramp up in 2023 and bring incremental benefit to the re-acceleration of revenues in the near-term. I have written other articles on Netflix that can be found here about why it is time to be bullish on Netflix.

Management top priority for 2023 is revenue growth

In the UBS conference, management stated that their top priority for 2023 is to reaccelerate revenue growth. Also, management expects that they will return to margin expansion over time as it looks to overcome the current short-term challenges. In terms of annual content spend, management did highlight during the conference that they believe that $17 billion is about the right amount of content spend they expect annually and will look to improve efficiency of this spend by ensuring that in 2023, the release slate is smoother and that more popular local content can make its way globally.

Ad tier and paid sharing initiatives update

With the launch of its advertisement tier, this does open Netflix up to new customer segments that were initially not targeted and also provides customers with more choice and options. As the ad tier is still relatively new and in the early stages, management expects to be flexible and adjust the offering over time and make improvements for both consumers and advertisers. There were also suggestions that Netflix may launch additional tiers beyond Basic over time. More importantly, management does not expect much cannibalism in terms of migration between plans based on their historical records. In addition, they do not expect incremental costs for running the new ad tier.

For paid sharing, with the learnings from Latin America, management is better able to manage paid sharing in its other markets. In general, management expects that the paid sharing initiative will have an impact similar to normal price increases and expects that there will be minimal negative impact when it is launched.

Guidance for the final quarter

For the guidance for 4Q22, Netflix expects that paid subscribers will increase by 4.5 million, which is higher than consensus expectations. This guidance does not actually take into account any material ad offering contribution. For reference, the ad offering was launched in November 2022 in 12 countries. In 4Q22, management expects $7.8 billion in revenues, mostly in line with consensus expectations and implies 9% growth on a constant currency basis. For operating income in 4Q22, management expects to generate $330 million for the quarter, slightly below the operating income expected by the street due to expenses being pushed from 3Q22 to 4Q22.

Netflix also decided that it will not be providing guidance on global subscribers going forward. This decision was primarily due to the increasing focus on revenues rather than subscribers as the business matures. At the start, Netflix focusing on subscriber numbers was key to demonstrating to investors how well it is growing. However, subscribers as a metric are now less relevant due to the fact that they have different price points and differing partnerships globally. What this means is that a subscriber’s eventual economic impact can be quite different, and this is not quite reflected in a simple subscriber count metric.

This is also more important, in my view, as we move towards 2023 and Netflix is starting to bring in new revenue streams like paid haring and advertising. As such, growth in membership may be less meaningful and the revenue growth metric might be more meaningful as we start seeing these new revenue streams ramp up.

The company will continue to disclose in each quarter its global subscriber numbers and net adds each quarter, as well as other guidance that management has given in this and prior quarters.

Valuation

Based on consensus estimates, Netflix does trade at a discount to its 5-year P/E range as it is currently trading at 26x 2023 P/E. While P/E is a function of growth, it is also a function of risk. As a result, despite having increased competition and likely slower growth than in the past 5 years, Netflix is starting to look attractive from the earnings and cash flow perspective as the company is actually sustainable and self-funding today. With success in its new initiatives, this could ignite and re-accelerate growth which might help drive a multiple rerating.

I use an equal weight P/E multiple method and the DCF method. For Netflix, I assume that its P/E for 2024 will be 26x, and I assume a discount rate of 12% and 15x terminal multiple for the DCF. With that, my 1-year target price for Netflix is $318, which implies an upside of 15% from current levels.

Risks

Deterioration of subscriber numbers

While subscriber numbers have in recent quarters met or exceeded the street’s expectations, now that guidance has been removed for subscriber count, this might cause further dispersion in the estimates for subscriber count. This uncertainty may cause a greater disappointment when subscriber numbers for a quarter comes in weaker than expected. While management states that they are focusing on revenues, subscribers as a metric remains relevant in measuring the operational health of the company.

Competitive pressures

Netflix used to be the king of streaming but now that so many other players are entering the market, Netflix will definitely feel the pinch. This has affected growth, subscriber count and market share as these new entrants are typically ones with strong market positions in their own industries and have a large stash of cash to spend to improve on their content. These companies include companies like Amazon (AMZN), Disney (DIS) and Apple (AAPL), that continue to add pressure for Netflix in its core product offering.

Weakening of the macroeconomic environment

While management may be taking the right steps to revitalize growth and drive a re-acceleration of revenues, the company may need to contend with a difficult market environment where consumer sentiment is weak. With consumer sentiment being weak in a weakening environment, there is no doubt a negative impact on Netflix’s attempts and bringing in growth.

Conclusion

Netflix does seem to be at a turning point today. 2023 will be a pivotal year for its turnaround story as it needs to start to show some progress in its goals to re-accelerate revenue growth. This is even more so as management has removed the guidance for subscribers and thus increased the street’s focus on revenue growth instead. For the management team, there is no doubt that their top priority is to re-accelerate revenue growth and thus, this goal does permeate top down in the company. With its new initiatives like paid sharing and ad tiers launching, this brings incremental benefits and revenues in 2023 as the company ramps up on these new growth drivers. At the same time, spending on content remains relevant and important for its core business to ensure that its streaming platform remains one of the best globally to retain existing subscribers and attract new ones. My 1-year target price for Netflix is $318, which implies an upside of 15% from current levels.

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Disclosure: I/we have a beneficial long position in the shares of NFLX either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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