Netflix: Q3 Shows No One Can Stop This Streaming Giant
Contributor since 2021 / 721 Followers
Summary:
- Netflix’s Q3 earnings beat top- and bottom-line estimates, showcasing strong revenue growth, improved operating margins, and significant free cash flow, reinforcing my BUY rating.
- The company’s robust content slate drives subscriber engagement and ads-tier growth, solidifying its lead in the streaming wars.
- Despite impressive ads-tier membership growth, uncertainty remains around monetizing ads inventory, with management indicating no significant impact for the ads business on FY25 revenues and profits.
- Valuation suggests a 14% upside with a price target of $782, supported by Netflix’s dominant market position and strong future content lineup.
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Investment Thesis
The last time I wrote about Netflix (NASDAQ: NASDAQ:NFLX) in July 2024, I analysed the company’s second quarter earnings report and highlighted how the company’s hybrid sports strategy should allow it to stay ahead of its competitors. I had a BUY rating on the stock.
Since my article was published, the stock has jumped 17.8%, handily outperforming the S&P 500, which only gained 5.2% during the same period.
In this article, I analyse the company’s Q3 earnings report and dissect the major developments, especially the progress of its ads business.
Third Quarter Highlights
Netflix had an outstanding quarter in my opinion with the streaming giant beating on top- and bottom-line estimates once again. Q3 revenues came in at $9.82 billion, up 15% y/y and beating analyst estimates by $57.65 million. Diluted EPS of $5.40 was up 44.8% y/y and comfortably beat estimates by $0.27. While global streaming paid memberships grew 14.4% y/y for the quarter, net subscriber additions saw a considerable fall, down 42% y/y. The third quarter of last year was when the company’s password-sharing crackdown took shape, which explains the y/y decline. However, the company’s focus on profitability was clear, as operating margins came in at 29.6%, much stronger than the 22.4% figure it attained during the same period last year. Operating margins were also ahead of the company’s own guidance of 28.1%. Free cash flows also showed considerable growth, coming in at $2.19 billion, an impressive y/y growth of 15.9%.
The company once again delivered strong guidance. Q4 revenues are projected to come in at $10.13 billion, a y/y growth of 14.7%. Operating margins for the fourth quarter are expected to come in at 21.6%, which would be a significant jump from the 16.9% it generated in Q4 of last year. Diluted EPS is expected to come in at $4.23, which would translate to a massive y/y growth of 100.5%. The company also expects paid net additions to be higher in the fourth quarter, on a sequential basis, due to “normal seasonality and a strong content slate.” If these Q4 estimates come true, then it would imply that FY24 revenues would grow 15% y/y (high-end of company’s full-year guidance) and the higher-than-expected revenues have led the management to project FY24 operating margins of 27% (vs. previous guidance of 26%). Finally, management expects FY25 revenues to come in between $43 and $44 billion (y/y growth of 11-13%) and FY25 operating margins to be at 28%.
Netflix’s Content Slate Demonstrates How It Has Won the Streaming Wars
The major highlight of the company’s third quarter, to me, was how the company’s content slate has managed to not only drive subscriber growth, especially in the ads-tier, but also enabled the company to deliver strong subscriber engagement. Subscriber engagement, a metric that NFLX uses to demonstrate customer retention, for Q3, came in at about two hours per member per day. This could be attributed to the company’s strong content slate, which included the likes of Perfect Couple, Monsters: The Lyle and Erik Menendez Story, and the latest seasons of Emily in Paris and Cobra Kai. It not only allowed the company to deliver strong revenue and margin growth, but also enabled it to build a strong membership base for its ads business, as evidenced by the 35% q/q jump in ads membership. The jump in ads membership has been so strong that it has exceeded the company’s ability to monetize its ad inventory.
Looking ahead, the company, in the fourth quarter, is set to launch one of the strongest content slates it has ever released in recent times in my opinion. This includes the likes of Season 2 of Squid Games, Season 4 of Outer Banks, and Season 7 of Love is Blind. At the same time, the company is also set to launch two of its most ambitious shows from Latin America:a biopic on legendary F1 driver Ayrton Senna, and 100 Years of Solitude, a show based on the iconic novel of the same name by legendary author Gabriel Garcia Marquez. Then, there is the much talked about Mike Tyson vs Jake Paul boxing match as well as 2 massive NFL matches on Christmas day, as the company ramps up its live sports programming ahead of the streaming debut of WWE Raw, which kicks off in January 2025. Finally, 2025 will also see the return of Stranger Things and Happy Gilmore along with new shows from Shonda Rhimes and Ryan Murphy.
In my opinion, NFLX has already won the streaming wars, as evidenced by its consistent revenue and profitability growth. The company even overtook a legacy Hollywood studio in the US for the first time, in Q3, with respect to demand for original programming. All of this can be attributed to its ability to consistently deliver high-quality content, which keeps users engaged. Q3 was no different. Moreover, for Q4, the company has already given some strong guidance, as mentioned in the previous section, which once again can be attributed to its content. The strong content slate has even allowed the company to increase prices in multiple regions, with Italy and Spain being the latest countries to join the list. As Netflix is set to finish the year on a high, the latest quarter proved why no competitor can come close to it.
Ads Business Shows Promise but Uncertainty Remains
When a company’s management comes out and says that it is unable to keep up with demand, it usually means positive news. While the same can be said about NFLX’s ads business, the uncertainty surrounding this business remains, which should leave investors uneasy, especially since I see its ads business as the next big catalyst for its growth. The positive takeaway, with respect to the ads business, during the third quarter, was the tremendous progress made by the company in growing its ads-tier membership. For the third quarter, as mentioned earlier, membership for its ads-tier grew 35% q/q, building on the 34% sequential growth seen in the second quarter. The ads-tier accounted for over 50% of sign-ups in countries where the company has introduced this plan. In terms of engagement, the company found that members in this tier were engaging with similar content as the non-ads plan members. Both sets also had similar views. All of these highlights are positive and banishes the questions surrounding cannibalisation of the non-ads plan and whether the ads plan would negatively impact both margins and overall profitability.
Having said that, there are still question marks surrounding the company’s ability to monetize its growing ads inventory. For a while now, management has mentioned that they are in the early stages of the ads business and that a lot of work remains to be done. Q3 was no different as the management, during the earnings call, reiterated this message. The company remains on track to launch its own ad server in Canada during Q4 before expanding it to the rest of the ads market in 2025. However, management reiterated during the earnings call that the ads business will not be making any meaningful contribution to its top- and bottom-lines in FY25.
The last time I wrote about NFLX, I did mention that investors shouldn’t judge its ads business harshly as it is making progress with each passing quarter. While I maintain that stance, I would have still preferred to see some more commentary on the progress made in this space. Instead, the message was largely the same as Q2. While there is no reason to panic given that the company’s content slate is too strong that it should help the company to grow even in FY25, the uncertainty surrounding monetization of its ads business is an area that I can’t ignore. If the same message is maintained in the fourth quarter as well, then it would be extremely concerning.
Valuation
|
Forward P/E Multiple Approach |
|
|
Price Target |
$782.00 |
|
Projected Forward P/E Multiple |
33.9x |
|
Projected FY25 EPS |
$23.06 |
Source: LSEG Data (formerly Refinitiv), Author’s Projections, and Company’s Q3FY24 Letter to Shareholders
As mentioned earlier, management expects FY25 revenues to come in between $43 and $44 billion. Given the company’s FY25 content slate, which includes the likes of Squid Games Season 2, Stranger Things series finale, a new season of Wednesday, a new Knives Out film as well as the arrival of WWE Raw, I expect the company to have a strong year overall. FY24 revenues are set to match the company’s high-end of guidance, which was also my estimate, and given that the content slate is even more attractive for FY25 in my opinion, I don’t see any reason why the company can’t repeat the feat again in FY25. As such, I have assumed FY25 revenues to come in at $44 billion, the high-end of the company’s guidance.
Management now expects FY25 operating margins to come in at 28%, expanding by a 100 bps from FY24. This is a reasonable estimate in my opinion, given that the company has been managing its expenses in a disciplined manner, an argument I raised in my previous article on the company as well. Therefore, I have assumed FY25 operating margins of 28% for my calculations, which translates to $12.32 billion.
I have assumed FY25 non-operating expenses for the company to be $708 million, which would be approximately the average net non-operating expenses in the last five years. I have left my effective tax rate assumption to be the same as last time, which is 13.3%. Taken together, this would result in total FY25 net income of $10.1 billion. According to the company’s latest income statement (unaudited), the weighted average shares of common stock used to calculate the diluted EPS was 437.9 million. Using this figure, FY25 diluted EPS is projected to come in at $23.06, slightly lower than my previous estimate of $24.23.
The company, according to LSEG Data, currently trades at a forward P/E of 30.8x, which is close to its historical 2-year forward P/E multiple of 29.7x. Given that the company is dominating the streaming landscape, and given the structural tailwinds such as a stronger content slate in FY25, struggling competition, and the untapped potential of its advertising business, I believe it needs to trade at its 5-year historical median multiple of 33.9x. As such, I have used this multiple for my calculations.
A forward P/E of 33.9x and a projected EPS of $23.06 results in a price target of $782, which is higher than my previous target of $734, and which suggests a 14% upside from Thursday’s close. I am maintaining my BUY rating on the stock.
Risk Factors
The main risk, in addition to the uncertainty surrounding the company’s ads business, to my bull-case, involves the potential issues surrounding live streaming, a point that I raised in my last two articles on the company. While the company has largely avoided any major issues for its live programming since the Love is Blind fiasco, the stakes are much higher for the company when it comes to the two NFL games on Christmas Day and WWE. Any issues would have a significant negative impact on both the future revenues and profitability.
Concluding Thoughts
NFLX had yet another outstanding quarter in my opinion, beating on both the top- and bottom-lines once again. Management also offered strong guidance, both for the fourth quarter, as well as for FY25.
The latest quarter perfectly demonstrated the company’s ability to keep churning out high-quality content on a regular basis. With some of its biggest hits returning with new seasons in the fourth quarter as well as in FY25, and with the arrival of both NFL and WWE in its live programming category, NFLX has all but won the streaming wars in my opinion.
If there is an area of concern, it would be the uncertainty surrounding the company’s ability to monetize the ads inventory. Despite seeing strong membership growth in its ads tier, the company, during the latest quarter, did not offer any new insights into its plans to monetize its ads business. Management merely stated that the business would take time to grow, and it would have no meaningful impact on the company’s revenues and profits in FY25.
From a valuation perspective, there is still upside from current levels. And with a strong grade of A- on Seeking Alpha’s Momentum scale, I won’t be surprised if the stock blows past even my updated price target. This is Netflix’s world, and we are all just living in it. Q3 was a testament to that.
Analyst’s 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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