Netflix: Show me the money

I am assigning Netflix (NASDAQ: NFLX) a positive risk/reward rating based on its leadership position in the global streaming market, discounted valuation, above-average growth potential, and its deeply oversold technical position coinciding with an incredibly strong long-term support zone.

Risk/Reward Rating: Positive

Netflix rattled the market when it reported Q1 2022 earnings on April 19, 2022, sending the shares lower by 45% over the following two weeks. The shock resulted from the loss of 203,000 members in Q1, and a forecast for Q2 2022 that calls for the loss of 2 million additional members. It should be noted that Netflix would have reported a membership gain of 500,000 in Q1 if not for the loss of its Russian members.

Growth

Nonetheless, the membership disappointment is material as the company had previously forecasted a gain of 2.5 million members in Q1, and a similar addition in Q2 2022. All told, Netflix is on pace to trail its original membership plan by over 7 million members through the first half of 2022. The following table displays the Q1 membership change compared to year end as of the end of Q1 2022 and Q1 2021, as well as the YoY (year-over-year) membership change in Q1 2022. The data was compiled from Netflix’s Q1 2022 10-Q filed with the SEC.

I have highlighted in yellow the year-over-year membership growth in Q1 2022 compared to Q1 2021. While membership declined in Q1 compared to the year-end 2021 member tally, membership continued to grow by nearly 7%. Notice that the Asia-Pacific market is the only region growing above 7%, coming in at an impressive 26%. The single digit growth rates excluding the Asia-Pacific region raise the question: is Netflix still a growth stock?

In my last Netflix review in July 2021, entitled “Netflix stock faces COVID hangover,” I assigned a negative risk/reward rating while stating the following:

The question for Netflix is whether 2020 was as good as it gets for the business. It is hard to imagine a better operating environment for the company than locking down the world’s population.

Netflix added nearly 37 million members in 2020, followed by 18 million in 2021. 2022 so far has seen sequential membership declines. It should be noted that management expects membership to grow in 2022, although no guidance was provided. 2020 in fact looks to be as good as it gets for Netflix and likely represents the company’s peak growth period.

Interestingly, in the Netflix Q1 2022 Earnings Interview, Reed Hastings (Netflix’s CEO) recounted the underlying trends in order to place the recent slowdown in perspective. He stated that COVID boosted business a lot in 2020, followed by a natural slowing in 2021 given the pull forward of demand during the height of COVID in 2020. With the sequential membership declines in the first half of 2022, he stated that the reversion to the mean (my paraphrase) following the 2020 demand pull forward no longer holds as a reason for the slowdown.

Membership Trends

I too had the impression that Netflix’s slowdown was a reversion to the mean in 2021 and into 2022 following the COVID-induced demand growth. What is interesting about Hastings’ commentary and my impression of the underlying trend dynamics is that the COVID-membership growth of 2020 and into 2021 was not materially outside of the existing growth trajectory pre-COVID.

Meaning, the membership growth of 2020 and 2021 was in line with what one would have generally expected if extrapolating pre-COVID trends into the future. While I have no doubt that COVID pulled forward demand in 2020, it is not clear that membership growth in 2020 and 2021 combined would have been materially different if COVID had never occurred.

The following table displays the total membership by region as of the end of Q1 2022 and the percentage of the total membership that each region represents. Note that the four columns to the right display the year-over-year membership growth rates for each region for Q1 2022 and the full years of 2021, 2020, and 2018. The data was compiled from Netflix’s Q1 2022 10-Q, 2021 10-K, and 2018 10-K filed with the SEC.

I excluded 2019 as Netflix began reporting the US and Canada together in 2019, whereas Canada was included in international prior to this. This caused a distortion of the regional trends in 2019. I have highlighted in yellow the growth trajectory for the US and Canada and in blue the growth trajectory for the international markets.

It is clear that the growth rates posted in 2020, 2021, and Q1 2022 are broadly in line with what one could have extrapolated from the existing growth trajectory as of 2018. The 2018 growth rates were in turn within a natural growth slowdown trajectory from prior years (not shown here).

In summary, COVID looks to have softened the slowdown trajectory for Netflix in 2020 while leaving the overall slowdown trajectory unchanged. The US and Canada appear to be fully penetrated, with Europe and Latin America reaching a more mature growth stage. At the moment, the Asia-Pacific region is growing rapidly and represents the largest growth opportunity, which should remain the case for the foreseeable future.

In studying the COVID period and its customer user activity, Netflix now believes that there are 100 million households using a shared password to access its services. This is a systemic problem on the platform at nearly half of the 222 million paying households. The company has now made it a priority to resolve the nonpaying user issue. This could breathe new life into the mature markets going forward.

Revenue Growth Trends

If the company can successfully monetize its 100 million nonpaying households, the revenue growth trajectory could receive a material uplift. For example, if Netflix can achieve $5 per month (subscription or advertising-based) from these users, this alone could add 20% to top line growth over the coming years. More importantly, this potential $6 billion of additional revenue would drop to the bottom line as the users are already using the Netflix platform and consuming its services. This will become more important when we look at the Netflix business model, its earnings, and its negative free cash flow generation.

As things stand, Netflix’s revenue growth trajectory is well above its membership growth trend. This is largely due to pricing power, as we will see. The following table was compiled from the same SEC filings used above and displays Netflix’s sales by region in Q1 2022, and the percentage of sales that each region represents. Like above, the four columns to the right display the year-over-year growth rates for each region for Q1 2022 and the full years of 2021, 2020, and 2018.

I have highlighted in yellow the US and Canada, and in blue the international markets. This is the same highlighting scheme used in the previous table for ease of comparison between member growth and revenue growth. In fact, management has guided to 10% year-over-year revenue growth in Q2 2022, even though it expects a sequential membership decline of two million. The driver of the expected revenue growth is price increases. The following table displays the recent pricing trends and was compiled from Netflix’s Q1 2022 10-Q filed with the SEC and with the recent price changes provided by Seeking Alpha.

I have highlighted in blue the key data for the US and Canada. Netflix recently announced a 10% to 11% price increase in the US and Canada following 5% pricing growth in Q1 2022. Comparing the membership growth and revenue growth tables above for the years 2018, 2020, and 2021, the average price increase for all markets averaged 10% per year. This is an incredible level of pricing power which will become increasingly important as membership growth slows going forward.

Whether or not this level of pricing power is sustainable will become a critical question for Netflix in the future. A cursory glance at the monthly membership fees above suggests that the pricing growth runway could be long and steady. While 10% annually is unlikely to persist, mid- to high single digits looks to be realistic over the coming five to ten years.

Consensus Growth Estimates

From the above member, revenue, and pricing trends, we can draw some conclusions as to the likely sustainable revenue growth rate for Netflix. To err on the side of caution, I ignore the potential monetization of nonpaying users. In the following table, I display the growth potential for Netflix under what I would consider to be conservative assumptions. The assumptions are 5% pricing growth per year for all markets (compared to 10% in recent years), zero new members in the US and Canada, and 10% membership growth in the international markets.

I have highlighted in blue the sustainable sales growth rate given the above assumptions, which is 10.69% per year. I view these assumptions as being very well-supported by the growth trajectory of each region. This serves as an excellent baseline from which to view consensus sales estimates. The following table was compiled from Netflix’s consensus estimates provided by Seeking Alpha.

I have highlighted in blue the consensus sales growth estimates for 2023 through 2026, as they are exactly in line with my 10.69% sustainable sales growth estimate from the prior table. Importantly, consensus estimates now look to be rather conservative. I say this because there appears to be little, or no benefit factored in for the monetization of nonpaying users, and the embedded 5% pricing growth is well-below recent trends. There appears to be upside sales surprise potential for Netflix entering 2023.

Turning to the consensus earnings growth forecasts, the estimates are decidedly more aggressive than consensus sales growth forecasts. While margin expansion is a distinct possibility for Netflix, there is less conservatism embedded in consensus earnings estimates compared to sales estimates. The following table displays the earnings estimates provided by Seeking Alpha. I have highlighted in blue the 2023 to 2026 period for ease of comparison to the consensus sales growth estimates above for the same years.

Looking at the PE column, if consensus earnings growth estimates are in the ballpark, Netflix certainly has material upside return potential from multiple expansion alone. The earnings estimates do not appear high enough to factor in a material benefit from the monetization of nonpaying users, similar to the sales estimates above. As a result, consensus earnings estimates look to be factoring in material margin expansion on the more conservative 10% sales growth trajectory.

If we assume Netflix can monetize the 100 million nonpaying users, there could be considerable upside surprise potential for earnings as well as sales. For example, $5 per user per month would equate to roughly $13 per share of pre-tax earnings, or roughly double the 2022 earnings estimate, after tax. I view this monetization as a matter of when and how much, rather than a matter of if it will occur or not. That said, whether monetization can average $5 per nonpaying user per month is open to debate and is subject to a wide margin of error.

Profitability

The margin expansion potential that is embedded in consensus earnings estimates is intriguing. On the profitability front, Netflix is a tale of two financial statements. From an income statement perspective, Netflix is rapidly growing its profitability. In just the past four years, income has grown from $559 million to over $5 billion, for a growth rate of 74% per year. The cumulative income reported over the past four years was just shy of $11 billion.

Looking at Netflix’s cash flow statement, over the same four years the company generated -$4.2 billion of cumulative negative free cash flow. In fact, Netflix has historically generated negative free cash flow with the exception of 2020, which benefited from less spending due to COVID constraints on entertainment production activities. The following table displays select line items from Netflix’s cash flow statement provided by Seeking Alpha.

I have highlighted in blue the reported income since 2012 as well as the 2020 positive free cash flow. The consistent negative free cash since 2012 is highlighted in yellow. Since 2012, the cumulative negative free cash flow stands at -$8.6 billion which has been funded by debt. Please note that the rows are a selection of the most pertinent cash flow statement data points and thus the columns as presented do not sum.

Comparing Netflix’s reported income to its free cash flow highlights a critical question for the Netflix business model: can it generate positive free cash flow? In other words, show me the money. Management has forecast that it intends to generate free cash flow in 2022 and onward. It looks likely that sustainable free cash flow can be achieved, however, the level and degree to which it can be maintained is highly uncertain given the lack of historical precedent. I made the following statement in my prior Netflix update:

Fresh content is a critical factor for future success in attracting and retaining membership. Given the wave of competition coming from content owners streaming directly to customers, such as Disney+, Netflix will have to ramp up investments in original content.

In this regard, speaking on the Q1 2022 earnings interview, management indicated that Netflix members expect one major new entertainment release per month. This is a rapid cadence for high quality content creation, which is likely to require sustained and significant content investments as some content investments will be failures. Additionally, Netflix is losing access to third-party content as content owners begin to stream directly to their customers, and the competition bids up the cost of the remaining third-party content that is open for license.

Balance Sheet

Time will tell regarding the level and sustainability of Netflix’s future free cash flow. To date, as mentioned above, Netflix has funded its negative free cash flow by issuing debt, and now carries $14.6 billion of long-term debt on its balance sheet. The following table summarizes the cash flow statement and places Netflix’s balance sheet in the proper context.

I have highlighted the cumulative negative free cash flow and cumulative debt raised over the past decade through 2021. Notice that the current cash balance of $6 billion (as of 3-31-22) is nearly identical to the cumulative net cash raised via debt issuance of $6.7 billion through 2021. In fact, Netflix repaid $700 million of debt in Q1 2022 which brings the cumulative net cash raised down to the current cash balance of $6 billion. The following table displays key balance sheet items and was compiled from Netflix’s Q1 2022 10-Q filed with the SEC. I have highlighted the key data points.

The key short-term items are cash and net current assets. While Netflix has plenty of cash at $6 billion, current liabilities nearly offset current assets leaving a positive $358 million of net current assets. On the long-term front, the key items are Netflix’s content assets and debt. Of note, Netflix writes down the majority of its content assets within four years of first use, so these are not necessarily long-term assets such as a building or factory, and carry highly uncertain value. It is the debt and content that are most important looking forward.

Debt

On the debt front, Netflix has made unusual choices given its recurring negative free cash flow. Meaning, one would expect such a company to try to extend debt maturities as long as possible to minimize refinancing risk given that cash flows are not sufficient to repay the debt at maturity. The following table was compiled from Netflix’s Q1 2022 10-Q filed with the SEC and breaks down its debt by year of maturity.

I have highlighted in yellow the debt maturity range, which ranges from 2024 to 2030, or just two to eight years until maturity. This is unusual as mentioned above. A recent decision in 2020 (highlighted in blue) adds additional mystery around Netflix’s debt management. Meaning, the corporate debt markets were wide open to issuers since Q3 2020, and at historically low interest rates until quite recently. Why Netflix would choose to issue a marginal amount of 5-year bonds in such an environment raises questions.

The questions surround whether these choices of shorter-term maturities are being made by management, or whether they are being made by the debt markets refusing to finance Netflix past ten years. Regardless of the answer, the reality is that it is either a negative signal regarding management’s long-term capital management strategy or a negative signal from the corporate debt markets as to Netflix’s long-term viability.

I find it hard to believe that the debt markets were not open to financing Netflix at longer maturity ranges. That said, management did mention on the Q1 2022 earnings interview that they had reached the upper end of their acceptable or desired absolute debt level. As a result, the lack of opportunistic debt management may reflect a combination of the markets hesitance to fund Netflix longer term as well as a management’s apparently casual long-term capital management strategy.

Content

On the content front, the primary shift that is occurring is the transition from third-party content to Netflix-produced content. This is critical to the Netflix investment case going forward. In the past, Netflix did not own the vast majority of its content. As a result, the cash outflows for content were more akin to maintenance capital requirements rather than an investment in new long-term assets.

With the shift to produced and owned content, Netflix’s incremental content investments should be more akin to long-term capital investments and thus provide longer-lasting returns on investment. The following table displays the key content trends and was compiled from Netflix’s Q1 2022 10-Q and Q1 2020 10-Q filed with the SEC. I have highlighted the key trends.

Notice that licensed content is now in a well-defined downtrend with a peak in Q1 2020 (highlighted in yellow). Netflix-produced content is rapidly expanding as can be seen in the blue highlighted cells. The 19% growth in Q1 2021 was due to COVID disruptions, compared to 66% growth in Q1 2020 and 44% growth in Q1 2022. Since 2019, produced content has grown from 32% of content to 59%, and is rapidly rising.

The advantage of owning versus licensing its content is a clear positive development for Netflix. On the other hand, Netflix is onboarding a greater degree of creative risk with its own production. If the quality of the content is not deemed acceptable by the marketplace, Netflix could experience increased churn given the high-quality competition.

As things stand, Netflix has been a top performer in recent times which is on display in its Academy Awards achievements. The track record suggests that Netflix can produce content with sufficient quality to attract and retain members. This conclusion is further supported by Netflix’s industry low churn rate at around 2.5% on average.

Valuation

Netflix’s content success to date is likely a primary reason for its successful customer acquisition and retention. With the investment shift heavily in this direction, the company will be building more durable long-term value with each passing year. This long-term value creation shift at Netflix is now being met with increasing value in Netflix’s collapsing valuation. The following table displays Netflix’s current valuation in relation to its 5-year average across several measures. It was compiled from Seeking Alpha and captures the sheer scale of the Netflix valuation collapse.

I have highlighted in yellow the range of the valuation collapse across the measures. The blue highlighted cells represent valuation multiples that most professionals would associate with highly mature growth companies. In other words, Netflix is being valued like a run-of-the-mill stock whose growth is in the past. In this light, Netflix’s PE ratio is below that of the general market averages, which are in the 19x to 23x range on forward earnings estimates.

The next table provides an industry valuation perspective and compares Netflix to several of its peers across various metrics. The data for each of the following companies was compiled from Seeking Alpha: Netflix, The Walt Disney Company (NYSE: DIS); Spotify Technology (NYSE: SPOT); Warner Music Group Corp. (NASDAQ: WMG); Warner Bros. Discovery, Inc. (NASDAQ: WBD); and Live Nation Entertainment, Inc. (NYSE: LYV).

I have highlighted in blue Netflix’s statistics and in yellow what I believe to be appropriate comparable companies. Netflix is trading at a 32% discount to the group using 2022 consensus earnings estimates (the PE 2022 row). The discount remains steep at 25% using consensus 2023 earnings estimates for each company (PE 2023, excluding Spotify). Interestingly, Netflix has a materially higher growth profile looking out at the 2024-to-2025-time frame, excluding Spotify.

The PEG ratio (second row from the bottom) provides a relative reference point for comparing the valuation of each company to each company’s growth profile. Based on estimated growth rates and existing valuations, Netflix appears to offer material upside potential from just being valued in line with its peer group. If Netflix deserves a premium valuation, the multiple expansion could produce quite impressive returns in its own right. Relative to both its historical valuation and the valuation of its peer group, Netflix offers material upside potential.

Technicals

The technical backdrop is fully supportive of Netflix offering material upside potential. In fact, the technical picture for Netflix is best described as extraordinarily oversold, which opens the door for large and rapid upside potential. The following 10-year monthly chart sets the stage. The green and blue lines represent long-term weekly and monthly technical support levels (downside targets), and the orange lines represent the key resistance levels (upside targets).

Notice the incredible speed of Netflix’s valuation correction from $700 to near $200 in just five months. For a company with a leading market position like Netflix to collapse with such speed, and without any meaningful rally attempts, is extraordinary. The lack of confidence in Netflix, excluding the reversal of extreme valuation conditions, is notable for future reference.

The shares are now testing long-term support that dates back to the middle of 2017 (the green line). This level should represent exceedingly strong technical support. The blue line displays the next major support level that dates to the middle of 2015. The 5-year weekly chart below provides a closer look at the key levels.

Importantly, notice that Netflix is over 50% below its 200-week moving average (the grey line). This alone quantifies the extreme oversold condition. While a test of the blue line cannot be ruled out, Netflix’s valuation and extraordinarily oversold technical position suggest that it is an exceptionally low probability. I fully expect the level surrounding the green line near $190 to offer a solid foundation of durable support. Zooming in to the daily chart provides a closer look at the oversold technical condition and the degree of upside potential to the nearest resistance levels.

Netflix’s 50-day moving average (the gold line) is near $342 per share or 73% higher from current levels. The 200-day moving average stands near $512 or 152% higher (the grey line). These figures speak powerfully to the oversold technical condition and the potential for an explosive countertrend rally.

Potential Return Spectrum

The return potential to each of the upside and downside technical targets is summarized in the following table, which also displays the return potential to fundamentally derived upside targets discussed above. I have highlighted in blue what I view as the most likely near-term return potential. The yellow highlighted cells represent high confidence return potential based on Netflix trading in line with its peer group’s valuation multiples. The outliers of -36% and +152% cannot be ruled out, however, the risk/reward asymmetry remains highly skewed to the upside.

Summary

Netflix represents an unusual risk/reward opportunity from an industry leader. While the growth slowdown is real, the shares have priced in this reality. In fact, Netflix has priced in a below-average future as can be seen by its relative valuation to the market, its peers, and its historical norms.

Netflix continues to possess above-average growth potential over the coming five to ten years. The shift to owned and produced content investments is a materially positive development from a sustainable long-term value creation perspective. This shift should continue to support Netflix’s exceptionally strong pricing power well into the future.

In addition to a long pricing growth runway, Netflix continues to have above-average growth potential internationally. Looking at the more mature markets, the potential to monetize unpaid users offers extraordinary upside potential. This monetization could then provide a powerful boost to free cash flow generation rendering its debt load immaterial. All told, Netflix offers a decidedly positive risk/reward asymmetry. Whether the company can ultimately succeed in showing shareholders the money, positive free cash flow, remains to be seen.

Price as of this report: $191.89

Netflix Investor Relations Website: Netflix Investor Relations