Netflix: My Updated Outlook After 68% Gains
Contributor since 2014 / 2953 Followers
Summary:
- Netflix stock bottomed as expected.
- Bill Ackman’s analysis was good, but his timing was poor.
- Netflix subscriptions recover, but margins fall.
- The outlook for Netflix under a new leadership model.
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In April 2022, I wrote an article on Netflix (NASDAQ:NFLX) stock, saying that hedge fund billionaire Bill Ackman had made a mistake on the streaming provider. The company is now up 68%, and I will discuss my latest thoughts in this article.
Ackman’s Analysis was Correct, but his Timing was Wrong
In my April article, I stated that investors could gain from Bill Ackman’s mistake. I had written an article in January of 2022, saying the stock had further to fall.
Three days after that article, the Pershing Square hedge fund founder announced one of his largest-ever investments in Netflix stock. Ackman bought over 3 million shares for his fund at a cost of around $12bn. He liquidated his entire holding shortly after for a quick $440 million loss.
I noted that Netflix had become overvalued in what has turned out to be the peak of a technology bubble, where valuations were handed out based on ultra-low interest rate financing.
At the time of the investment, Ackman said, “The opportunity to acquire Netflix at an attractive valuation emerged when investors reacted negatively to the recent quarter’s subscriber growth and management’s short-term guidance.”
That proved to be a short-sighted assertion, and I noted that Ackman’s impatience in going all-in was also likely driven by emotional bias. “We have greatly admired Netflix both as consumers and as investors, but have never previously owned a stake in the company,” he said. Ackman’s decision to ignore the bigger picture proved costly but the stock has since rallied over 60%.
Ackman had lauded the company at the time for its recurring revenues, economies of scale, and strong management team. He was right to pursue Netflix but got his timing wrong.
Investors can look at my January article: “Netflix Just Sent the Market a Warning,” where I discussed the valuation problem in the market and how analysts had failed to spot the pandemic-driven activity in subscriptions.
Netflix Adds Subscribers but Margins Drop
From a valuation perspective, Netflix trades at a price/equity ratio of around 36x earnings, which is -63% lower than its historical average, according to Seeking Alpha data. Valuations based on enterprise value are also down 36% against sales and 53% against EBITDA.
That suggests that there is still some upside available in the stock, but we must look at the changes incorporated from the bear market sell-off. I said in the April article:
With gross margins of 46% and an operating margin of 20% there is work that can be done by management to slim down the company. The company’s cash flow situation had been improving and this stock market collapse is maybe the shock that management needed to refocus on the balance sheet.
Unfortunately, gross margins have slipped to around 39.4% and net margins are lower at 17.8%. The problems with the company’s operating margin were due to the gains in the US dollar. The company said: “Based on F/X rates at the beginning of 2022 and excluding the $150M in restructuring charges in Q2’22, this translates into an operating margin of 20%, at the high end of the 19%-20% target we set in January of 2022.”
There was a big change at the company in January as the company’s co-CEO Reed Hastings stepped down from his role. Hastings will take on an executive chairman role, which was announced as the company unveiled better-than-expected fourth-quarter earnings.
Netflix said members had increased by 7.66 million, to 230.75 million total, between October and December. That beat the company’s own October guidance which had anticipated 4.5 million new members. It also beat analysts’ expectations of around 4.57 million. That was a welcome boost after the company announced its first loss of subscribers in a decade earlier in the year.
The Outlook for Netflix Under New Leadership
The recent earnings were also an opportunity for the new management team to outline their plans for the future.
When probed about the valuation reset, Netflix management noted that in the U.S. they are “about 8% of TV time still”. What has happened with the reset in Netflix is the same at many tech companies, where the valuation bubble has burst and now management has to pivot to real growth and business model changes.
“There’s not a lot of massive pivots away from a traditional legacy business model that we have to go figure out,” said Greg Peters, COO and Chief Product Officer. “We’re planting some seeds in terms of games and things like that, that if we execute well, and we’re excited about the progress we’re seeing so far, will represent the future potential for us in terms of more profit opportunities.”
The company’s CFO Spencer Neumann added to the outlook for a larger market share, saying: “There is no country where streaming is more than 40% of share of TV time. And in many big countries, as you saw, it’s less than 5%… So there’s an incredible runway still in the shift from linear to streaming. And so for us, it’s about growing into that shift and also obviously competing well and continuously innovating and improving”.
The reality for investors is that Netflix was overvalued in a tech bubble and sent shockwaves through the market with a subscriber loss that was warped by pandemic gains. The company now has to go and alter its business model to be a legacy media giant, and that could see a pivot to a model that includes sports, or games.
One recent change by the company was to tackle password sharing, which is said to affect 100 million accounts worldwide. However, a recent survey by Jeffries suggested that 62% of respondents would stop using Netflix, with 25% saying that they could not afford it, 31% saying they did not like the content enough to pay for it, and 35% saying they could find another service. This suggests that there could be some choppy earnings ahead for Netflix while it works out its core business model and aligns it with Wall Street’s expectations.
However, the company’s CFO was optimistic about the new business model changes. “Throughout the course of the year, we would expect to see accelerating revenue growth as we roll out paid sharing broadly across our business and then, obviously, scale adds throughout the year, which is a more gradual build.”
Conclusion
Netflix stock has rallied 68% from my buy recommendation in April 2022. The historical metrics also suggest the company is lower by historical standards, but that has been skewed by the company’s growth years and a low-interest rate tech bubble. Netflix has introduced a new management model and the team will have to work on its business model after some easy years of growth. The company is correct that there is a big future in streaming, and the valuation pivot has probably been a good thing in the long run. There are doubts about the appetite for non-password sharing, but that will simply remove non-paying users, and some of those threatening to walk away may not know about the advertising-based model. I would place a hold recommendation on Netflix here, and investors should look at how the new advertising model adds to the company’s revenues in the year ahead. Some consolidation could come after the recent gains as the company adjusts to the new reality.
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.