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Netflix: Tune in or switch off?
Some share prices can seem immune from market turbulence, as has been the case for Netflix recently. While major indices like the FTSE 100, S&P 500, Nasdaq, Eurostoxx 50 and Hang Seng have struggled since the start of September, the streaming TV and movies giant has defied gravity.
Over the past month the stock has outstripped the Nasdaq Composite’s (the US tech market where it is listed) single-digit declines and appreciated substantially, pushing the share price to all-time peaks of around $640.
Shares seldom dedicates an entire lead feature to a single company but there are some stocks that so captivate investors that they command the lone spotlight. We believe Netflix is one of them, as Tesla and Amazon have in the past in Shares.
A record share price at a time when overall stock markets are out of sorts will have many investors slamming the door shut. On the other hand, Netflix has its shareholder zealots that will see opportunity where others see irrational exuberance.
In this feature Shares will try to fairly weigh the pros and cons, explain how the company addresses key questions about its future, and provide an answer to the key investment question – should you buy Netflix ahead of its third quarter earnings on 19 October?
The bear argument is easy to grasp. Subscriber growth is slowing, competition is intensifying, huge piles of cash are needed to keep content fresh, while the company already has enormous debts to service, forecast to approach $10 billion by the end of this year.
For many, this leaves the firm’s $280 billion market value looking hugely stretched, implying as it does a 2021 enterprise value (EV for short, which includes net debt) to revenue and EV/EBITDA (earnings before interest, tax, depreciation and amortisation) of 9.5-times and close on 42. High-teens EV/EBITDA is typically considered racy.
The price to earnings multiple is pitched above 61 on this year’s forecast $10.44 earnings per share.
The bull case is also easy to understand. Competition is over-egged, cash burn is set to dramatically reverse over the next few years, most of its $10 billion net debt is long-dated and balance sheet efficient while the company has only scratched the surface of its global growth opportunity.
Analysts have identified 1.4 billion potential homes for the company to target worldwide, leaving its global penetration rate below 15%.
Netflix has come far since its origins as a DVD rental by mail service, morphing into a pioneer in subscription video-on-demand and the largest online TV and film service in North America, where it had just shy of 74 million subscribers as of 30 June 2021.
These days it has more overseas customers with about 135 million worldwide (excluding US/Canada) across more than 190 countries, including approximately 31 million in the UK, according to Ofcom stats.
Streaming video adoption continues to happen at a fast pace across the world, which should boost Netflix’s subscriber base and revenues over time, but the transition was given a huge push by the Covid pandemic.
DM Martins Research data anticipates more than 10% compound annual growth rate for the streaming sector over the next three years.
New streaming services have been coming thick and fast, with the likes of Disney+, HBO Max, Apple TV, Amazon Prime Video, Hulu, Britbox and many others stepping up the competitive threat.
We believe the debate has moved beyond which streaming service to choose, with increasing numbers of people happy to subscribe to two, three or more services.
But the wider reality is that Netflix is fighting for your attention against much more than other streaming services, with linear TV, DVDs, reading a book, surfing YouTube, playing video games, socialising on Facebook, going out to dinner or to a bar with friends all recognised by the company as competition for our time.
BUSINESS IS IMPROVING
Netflix earns just a fraction of consumers’ time and money, but it believes in the opportunity to win a bigger share of consumers’ leisure time if it can keep improving.
Part of that improvement strategy is a future increasingly dominated by original and exclusive content, which is where most of the firm’s programming investment has been going in recent years.
It has scored critical and popular success, and this year racked up nominations and wins for both film and television awards for its original content, including 44 Emmy Awards and seven Oscars, the most awards of any studio at the 93rd Academy Awards.
Netflix is responsible for popular series like Stranger Things, The Crown and Bridgerton, and more recently hitting gold with The Queen’s Gambit and Squid Game, while astute rights-based acquisitions will help, such as its recent deal for the rights to all the Roald Dahl books. The latter provides an opportunity to extend its reach into merchandise, theatre and more using a rich library of beloved characters.
Tiered subscriptions, sponsored content and even advertising are all options to pursue, although Netflix firmly believes that now is not the time to mess with a model that works. However, expansion into streamed gaming looks like the next big step.
Last month it agreed its first acquisition in the gaming space to buy video games maker Night School Studio, as well as releasing plans to roll out five mobile gaming titles in select European markets, including Spain and Italy.
Netflix is increasingly balancing new subscribers with profits.
It sees operating margins moving higher for ‘years to come’, having expanded from 7% in 2017 to 18% last year. The company is targeting 20% in 2021.
Beyond that, it is aiming for average 300 basis point annual margin gains, although this will have to be judged over a multi-year period because of the inherent bumps of largely upfront production costs.
The move into making more of its own shows is a big deal for Netflix, one that has put huge pressure on cash flows. This is not surprising, it’s obvious that making TV shows requires spending large sums to get production in motion before getting payback down the line as costs are amortised.
Content amortisation represents the vast majority of Netflix’s cost of revenues but that also covers other production costs, such as content personnel, physical production, post-production, music rights and overall deals. This can all be monitored by investors by watching the firm’s accounts – cost of revenues sits on the profit and loss account, or P&L for short.
Similarly, investors can see how much Netflix is spending on new and bought content by looking through the cash flow statement in the company accounts, where the sum of ‘Additions to Streaming Content Assets’ and the ‘Change in Streaming Content Liabilities’ equates to its cash spending on streaming content.
Netflix believes that cash flow pressures will ease in time and that investors will see the gap between net income and free cash flow narrow over the next few years. Importantly, management says they see no need for external financing to fund day-to-day operations, making net debt more consistent and manageable and relieving the threat of selling new shares to investors to raise fresh capital.
For the time being updates to the number of net new subscribers seems likely to dominate how investors react to the stock.
Stay-at-home orders during the Covid-19 pandemic drove business for Netflix as consumers watched more television because cinemas, live music and sports were shut down.
Netflix guided for 3.5 million net new subscribers in the third quarter. This would be better than 2020’s 2.2 million third quarter increase but down sharply on the 6.8 million subscribers the company added in the pre-pandemic third quarter 2019. But it would also mark a steep acceleration over the approximately 1.5 million net new members added in the second quarter of 2021.
The quarterly guidance Netflix gives the market is the company’s actual internal forecast at the time it reports and is primed for accuracy, not conservatism, which leaves it more exposed to surprises, both good and bad.
But it makes sense since giving a more cautious steer could mean under-investing in content and marketing. This does make for a more volatile share price in the run-up and in response to trading updates and financial results.
Netflix posted $2.97 earnings per share on sales of $7.34 billion in the second quarter, lower than analysts had expected, with consensus pitched then at $3.18 earnings a share on $7.32 billion sales. On a year-on-year basis, Netflix earnings jumped 87% while sales rose 19%.
For the third quarter, Netflix expects to earn $2.55 a share on sales of $7.48 billion. In the same period a year earlier, Netflix earned $1.74 a share on sales of $6.44 billion.
TUNE IN, OR SWITCH OFF?
So, are the shares worth buying or not? We definitely see scope for more earnings growth over the coming years as overseas markets open up with faster broadband connections and mobile networks, while Netflix has put to bed any doubts that it will struggle to be a maker of top drawer TV and films.
A brief to become self-sustaining and improve both cash flows and margins could make for exciting share price returns in the years ahead, and there are many fund managers who would argue that by not focusing very much on quarterly subscriber gains and earnings is precisely its appeal for longer-term investors.
Yet Shares is still left with nagging doubts about how much investors are being asked to pay for this potential, especially in the wake of the stock’s recent surge.
WAIT FOR A BETTER ENTRY PRICE
In conclusion, investors should not rush to buy Netflix stock ahead of next week’s update. There are too many unpredictable moving parts that could upset the share price short-term and leave new buyers dissappointed.
Longer-term, we would want to see more evidence that the company can keep growing while pushing profit margins up. We think there is scope for the business to raise its prices a lot more than current levels. After all, Netflix is seen as a must-have in so many households that people treat it like a utility bill, paying it whatever the cost.
To be frank, we’re frustrated that the shares are not a straightforward ‘buy now’ situation.
After all, this is a business which provides a service that a lot of people around the world crave. Strategically it is making good progress with improving the quality of its content and expanding into new areas. It is ticking a lot of the right boxes from an investment perspective.
Investors prepared to take a long-term view might be happy to pay the premium price to own the shares today. But we have a feeling there could be a better entry point soon, so sit tight and wait for a pullback before pressing the ‘buy’ button.