Netflix: No Longer Screaming Appeal For This Streaming Business
Contributor since 2011 / 24253 Followers
Summary:
- Netflix has seen increased momentum again in terms of net additions.
- This is in part driven by the crackdown on password sharing.
- This will drive further growth, as this practice and emerging advertising revenues will boost sales and margins in the coming quarters.
- Further growth is seen here, badly needed as expectations have risen substantially over the past year, amidst modest improvements in the business.
Wachiwit
In the summer of last year I called shares of Netflix (NASDAQ:NFLX) a streaming buy as its shares suffered from a major valuation correction, alongside the rest of the technology sector. After being a longtime critic given the premium valuation, I saw appeal emerging, although that it was not a certainty given the competitive dynamics.
After some incremental improvements are seen in the business here, I am much more cautious here as shares have doubled over the past twelve months, raising the bar a great deal despite green shoots arising.
Creating Some Perspective
After shares of Netflix traded at a peak valuation of $700 per share towards the end of 2021, shares traded at just $220 in July, and that was after shares rallied some $60 in the weeks beforehand.
Trading at the lowest levels since 2017, investors were pricing in slower growth and multiple contraction amidst competition being on the increase, with even some subscriber losses seen for the first time in about a decade.
Pre-pandemic, Netflix grew 2019 sales by 28% to $20 billion, posting relatively solid operating earnings of $2.6 billion along the way. Net earnings of $1.9 billion looked solid, but cash flow dynamics were not that great with content spending (the equivalent of capital spending) being very high for Netflix.
The pandemic provided a boom during 2020 with sales advancing to $25 billion, but the real advancement was made on the bottomline as operating earnings improved to $4.6 billion, in part aided by delayed productions which aided margins a great deal. As shares rallied to the $500 level, the company traded around 100 times earnings, nosebleed valuations with comparables getting more difficult as well of course.
This is despite the long term promise as the company would tackle multilayered accounts (and password sharing practices) as well as the ground to be gained if the company would move into adjacent markets like games, for instance. On the other hand was that of continued increase in content liabilities and competition heating up with established players looking to move into subscription based models as well.
2021 revenues advanced further to $29.7 billion with operating earnings advancing to $6.2 billion, with earnings improving further to $11 per share with the company guiding for flattish subscriber growth, in fact some temporary losses. With earnings power trending at $12-$13 per share in the summer of 2022, valuations looked a lot friendlier already at a market multiple.
Of course there was the issue of increased competition, but on the other hand, the company was eating competitors alive from many operating points of view.
A Big Recovery
Fast forwarding from July of last year, shares of Netflix have doubled to $427 per share at the moment of writing, although that shares have fallen from a high of $485 per share in recent weeks.
The company has seen a few tough quarters in 2022 after net customer losses totaled 0.2 million users in the first quarter, increasing to a million in the second quarter. Growth returned in a convincing manner in the third quarter as Netflix added 2.4 million subscribers during the quarter and added as many as 7.6 million new subscribers in the final quarter, pushing up the streaming paid membership base to over 230 million members.
Despite these additions, fourth quarter sales of $7.9 billion were up just 2% as full year revenues came in at $31.6 billion. The growth slowdown, in part due to a stronger dollar, made that adjusted operating margins of 20.0% fell 160 basis points on the year before. GAAP earnings of $4.5 billion translated into diluted earnings of $9.95 per share, down from $11.24 per share in the year before.
The company guided for a slight acceleration in the pace of revenue growth in the first quarter, on the back of the more recent momentum in terms of the membership numbers. First quarter revenues for 2023 rose by nearly 4%, although that net additions rose by just 1.7 million members. Second quarter sales rose by less than 3% to $8.2 billion, albeit that net member additions rose by 5.9 million users to more than 238 million members.
Note however that sales growth is set to accelerate as the company has started to launch paid sharing in more than 100 countries which represent the vast majority of the revenue base. Note however that this is a gradual process and is not set to immediately drive revenue growth to its full extent. These dynamics will result in accelerating sales growth, with third quarter sales seen up 7% year-over-year, aided by a recent pullback in the dollar as well.
Further growth acceleration in seen in the fourth quarter on the back of greater conversion of these trends, as well as a real contribution starting to be seen from advertising being rolled out. The third factor and driver is that the current low price offerings are no longer offered, only being maintained for current users, which makes that there are multiple drivers which should accelerate revenue growth from here, after a tougher past twelve months.
While revenue growth has not been too impressive, Netflix has been able to boost margins so far this year with diluted earnings per share for the first six months coming in at $6.73 per share, fifty five cents ahead of last year, making an $11-$12 run rate realistic for this year. In the meantime, net debt of $6 billion is firmly under control.
What Now?
The truth is that shares of Netflix have doubled over the past year, raising expectations after a tougher period from an operating performance perspective, a period in which revenue growth came to a near standstill and earnings have actually come down a bit.
That being said, there are real reasons to become upbeat with revenue growth acceleration seen in the coming quarters with password sharing being addressed, net additions seen again, advertising revenues being targeted and content spending actually coming in flat. This should provide a huge boom to operating margins, the extent of which is hard to exactly model.
If we assume that operating margins might grow from a low twenty percentage here to 30% (or see a combination of revenue growth with less impressive margin achievements) that yield 50% earnings growth over time, which is a big if.
Note that this is not as easy as simply seeing higher margins numbers, as the topline will see a boost from the crackdown on password sharing as well as executives previously believed that over a hundred million users across the globe are engaging in these practices. Even if just a fraction of these would sign up for new user accounts, that could be a major driver for the topline.
Even in that case, earnings per share might advance to $16-$18 which translates into a 23-27 times multiple, down a great deal from a current 35-38 times earnings multiple based on earnings power of $11-$12 per share.
Concluding Thoughts
The reality is that after being upbeat on Netflix last summer, shares have seen huge momentum and quite frankly I do feel that valuations are a bit rich with no strong operating momentum seen over the past twelve months. That said, the prospects for the coming quarters are rapidly getting better, both in terms of sales and margins, the extent of which is hard to estimate.
Given all this I am cautious here as content renewal is key in a fiercely competitive market, in which households are strained by inflationary pressures. In that sense the Hollywood strike is casting a shadow on the entire industry, provide a near term uplift to margins, but with some uncertainty for the medium term (churn) prospects.
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