In my last article, I noted that the fall of Netflix (NASDAQ: NFLX) stocks after the Q4 earnings release were excessive and the company’s stock became attractive as an investment. Then I formed half of my position in the shares of the company. I left the other half to buy shares of the company at the end of March, when more content was to be released (the second season of The Bridgerton tv series, the Project Adam movies and more). However, the company’s shares showed no significant recovery at that time. Besides that, there was uncertainty regarding the suspension of service in Russia and the acceleration of inflation around the world. Due to rising costs, some households, in my opinion, may have terminated their Netflix subscription before the time for heavier content delivery. Having waited for the report, I certainly didn’t expect a further 35% drop in the company’s stock. Despite weak reports and another weak forecast, I remain bullish on the company’s stock. In this article, I will inspect the published financial statements and share my thoughts on why I continue to view the company’s stock as attractive. Let’s start with the analysis of current results.
The preview of 1Q
Revenue was $7.8 billion (+10% YoY, 1% below consensus). Operating income rose 1% year-on-year to $1.9 billion (12% above consensus). EPS was $3.5, down 6% from a year ago, but 21% above consensus. The company unexpectedly showed a quarter-over-quarter subscriber outflow. The number of subscribers at the end of the quarter was 221.6 million, down 0.2 million from the previous quarter and 1% below consensus expectations. Leaving Russia led to a drop of 0.7 million subscribers. Net subscriber inflow outside Russia was 0.5 million, still below management’s forecast of 2.5 million. I attribute this in part to the content release schedule, but even adjusted for that the numbers are very low. Management has identified several reasons for these weak results, including increased competition, an increase in the cost of a subscription in several regions. However, the main obstacle to growth, according to management, is that approximately 100 million households do not pay for a subscription separately (30 million in the United States), but share the subscription with other households. Investors took this information negatively. This is because Netflix’s addressable household penetration has proven to exceed investor expectations, limiting further growth opportunities. My estimate is that Netflix’s potential global market (outside of China) is 600 million households. Current penetration is 37%. However, if you consider the additional 100 million households that share accounts, penetration is already around 54%. Had the strong subscriber growth continued, this news would not have spooked investors so much, but overall it led to a stock sell-off. Previously, this problem was not a priority for the company, now the management plans to focus on its solution. I think it will soon be possible to reduce the number of devices within one account and introduce separate fees for adding new users to the subscription. Such a system is already being tested in Latin America.
The weak forecast for the 2nd quarter
For the second quarter, the company expects a churn of 2 million users, which certainly disappointed investors again, with consensus calling for a net influx of 2.5 million. To make matters worse, management expects EBIT margins to be 20% through 2024. Why is this bad? Previously, the company was able to improve its margins by 2-3% each year. Many investors assumed this would continue. This is partly why Netflix has historically traded at a premium to its peers. After the fall, this bounty disappeared. I note that the strengthening of the dollar causes additional pressure on margins. I believe management has taken a conservative approach to margin forecasting and there is still room for long-term margin expansion. Also, expectations for user flow by Q2 seem very conservative to me. Still, the release schedule in the second quarter is more intense than in the first, and the long-awaited release of the sequel to the series is awaited – the release of the 4th season of stranger thingsthe next season of The Umbrella Academy, Ozark, and much more.
However, from a seasonal point of view, the second quarter was the weakest. For example, in the second quarter of 2021, the net inflow was the lowest in 2021, 1.6 million, while in Q1 and Q3 the figure exceeded 4 million. In the fourth quarter of 2021, there was an influx of over 8 million. Although the actual results and forecast disappointed the market, I continue to believe that the company has several opportunities for business growth, in addition to monetizing households that share accounts. Let’s look at them in more detail.
During the conference call, management discussed the possibility of creating a combined subscription plan (subscription + advertising). In this case, the subscription costs will be lower, but it will allow the company to collect additional advertising revenue. Competitors charge for this type of subscription on average 40-50% less than the premium (ad-free) version, but due to advertiser demand, the total ARPU may exceed the subscription ARPU. Given the change in IDFA policy and Netflix’s user base, some advertisers will be very interested in diversifying their advertising budgets and will choose to allocate part of their advertising budget to Netflix. A premium subscription, user engagement, expressed in hours viewed, does not directly affect subscription revenue. In the case of a combined subscription, the advertising revenue will depend directly on the engagement. More time watching series and movies will give the business more opportunities to add ads and therefore generate more revenue. Although the release schedule was limited to the first quarter, the content that was released attracted increased attention from the public. The second season of The Bridgertons has 627 million hours watched, more than the first. Also, the series Invent Anna (513 million hours viewed) and the documentary series The Tinder scammer (166 million hours watched) met with unexpected success. Such high subscriber engagement when switching to a blended subscription could lead to a significant increase in revenue for the company through advertising. Additionally, this combined form of subscription may appeal more to households in developing countries, where the cost of cable television is much lower than in the United States and where it is more difficult to compete with cable television.
Management noted that the major problem is not on the input side, but on the subscriber output side. Compared to the dense fourth quarter release schedule, the first quarter was sparse for new releases, so some subscribers did not renew their subscriptions. I see the best opportunity to solve this problem is to shift to releasing new episodes in a few months, rather than releasing the entire season all at once. There were no explicit comments from management on this. However, the company seems to be moving slowly in this direction. So last year, the last season of Money theft was released in several parts, in September and December. A similar pattern is planned for the release of the last season of Stranger Things (May, July) and several other TV series for this year.
Given slower content investment growth, I expect FCF margins to improve and FCF to be positive by the end of 2022. FCF margin has increased significantly (from 12% a year earlier to 19 %) in the 1st trimester. Seasonally, there is the least investment in content in the first quarter. In the second half, the investment in content will be higher, but by the end of the year, I expect the company’s FCF margin to be at the 8% level, which implies 18 billions of cash investments in content. To get an idea of what $18 billion is or isn’t, the average budget to make a movie is around $125 million. With this budget, $18 billion would be enough to make 144 films. Shooting a TV series costs less for the company, which will allow you to create even more content. However, there are also exceptions. For example, for the last season of stranger thingsthe company spent $30 million per episode.
I rate Netflix as the leader in entertainment content investment. But it trails only Comcast ($22.7 billion) and Disney ($18.6 billion) in combined content investments (entertainment, sports, and news). In the long term, in my opinion, there is an opportunity to increase the FCF margin to 22% by reducing cash outflows to invest in content. My long-term goal for content spending is $22 billion.
The Risk and Final Thoughts
Although several risks have already materialized, investing in Netflix is not without risk, even at the current level of stock prices. Several risks remain such as a continuous loss of subscribers, an increase in the cost of creating content due to inflation, a refusal to subscribe due to a decline in the purchasing power of the population, and others. All of the risks of investing in company stock can be found in the company’s annual financial statements (10-K). I still view this drop as a long-term investment opportunity, although the markets are looking for a period of monetary tightening which will certainly add volatility to Netflix stock as well. However, current levels are attractive to me, so I remain bullish and have increased my position in the stock.