Wachiwit
Netflix (NASDAQ:NFLX) seemingly declared that the streaming wars were finished with its triumphant fourth-quarter report (issued on January 23, 2024) and celebratory conference call. At the very least, I have heard pundits declare as such.
I’m not certain that the wars are finished in a definitive sense, but it was a nice report, and the price action defined a victory of sorts.
Price action, though, can change on a dime; euphoria in the markets can quickly turn into malaise when you’re not paying attention.
That isn’t the beginning of a bearish take; it’s just to point out that pullbacks are always an investor’s friend at earnings reactions like these. (I am writing this around the time of the report, so by the time this is published, there might already be pullbacks afoot.)
I continue to like the stock for the long term. Yes, I trimmed some of one position I own in a long-term account to make room for other buys in a bid for proper portfolio management (and I’ve owned that position for a very long time), but I opened a new position in a shorter-term trading account to take advantage of technical movement (which I might sell at any time, and then re-enter, et cetera).
The reason is clear: at 260 million members, the Netflix future everyone anticipated has come to pass (again, seemingly): Cable consumers may continue cutting cords, but the one service they will always start with will be Netflix, and then they will build from there. All other services then have to compete for the subsequent slots on the cord-cutters’ entertainment universe.
That scale seems to be working for the company – cash flow is no longer the big if-proposition it once was (although the company can always use more cash-flow growth to really hammer home that point).
The other big element to the story, a recent one, is advertising. I believe the company will optimize that over time into a significant growth engine.
In this article, I will go over some of the numbers and take a look at how Netflix is now perceived in the industry: as the top player that will use advertising to grow revenue-per-member and as a marketplace for content licensing from other producers.
In a previous article, I was similarly bullish. And also similarly cautious in terms of the Fed-driven potential for volatility in the markets. I also summarized some catalysts for the long-term with video games, advertising, some ideas concerning how Netflix could utilize artificial intelligence to allow users to create content (yes, I believe that could be a thing someday, and in fact should be something for Netflix to explore aggressively), and a specific deal with Skydance Animation. Animation is a field in which management wants to increase exposure, and not only should it want to do that for purposes of producing great content, but it should also want to leverage the format to power a potential consumer-products uptick (which I will mention later). I will briefly update some thoughts on advertising as well as reiterate my call for a multiplex strategy – this is a top concern for the company: don’t become lulled into thinking it doesn’t need to get its content onto the silver screen to increase revenue streams and promote the service.
The Quarter
As I just mentioned, the company has over 260 million worldwide users at this point. The last two quarters have seen double-digit year-over-year growth rates (over 10% and 12% in Q3 and Q4, respectively). Average revenue per individual member has remained mostly steady-to-slightly-rising at about a 1% growth rate. The great thing about that is the future impact of advertising…that metric will likely expand as not only the advertising market rebounds in the next couple years, but perhaps more importantly, the company becomes more comfortable and acclimated with its new skill set in programming and selling commercial time.
Free cash flow in Q4 was $1.5 billion versus $0.3 billion a year ago, and for the full year it was $6.9 billion versus $1.6 billion in fiscal 2022, but in reality, I think you can safely adjust the larger number down such that it becomes a comparison of $5.9 billion against $1.6 billion because of about $1 billion worth of strike-related investment timing. Nevertheless, we all get the point: free cash flow is a lot better today than it was yesterday. And I do want to see more of the proverbial levers pulled to ramp that up even further, whether it’s pricing power or reduction of content spending. Better yet, I’d rather see a higher yield of content hours per billion bucks spent. Projections for cash flow in the upcoming fiscal year call for $6 billion (versus that $6.9 billion), so you get the idea of what I’m driving at.
Lastly on the numbers is the debt. Total long-term obligations remained steady at $14 billion, and I would like to see that metric decrease more aggressively. I get that net interest expense was less than $50 million for fiscal 2023, and that the company has a $250 billion market capitalization – the problem is I see the interest expense of $700 million and wonder how much more content could be incubated if that was either reduced significantly or eliminated entirely. I tend to look at debt differently than most, and would trade some of the stock repurchases in favor of debt reduction, as well as even consider secondary offerings if the stock continued to rocket higher in the short term from here. Many would disagree.
Netflix’s Long-Term Story Enters New Chapter
The new chapter I speak of is the perception that Netflix can consider itself the absolute victor of the streaming wars.
Without a doubt, the company is the dominant player right now.
That isn’t to say, however, that the company can’t attempt to figure out ways to disrupt itself and change accordingly before some other entity (or trend) does the disruption for it.
As an example, Netflix’s scale and its investment in this new world that trades linear loyalties for broadband over-the-top services has given management the incentive to eschew any sort of establishment of an ecosystem beyond its all-in approach to streaming. Yes, Disney (DIS) may have seen its stock tumble because of its own all-in approach to streaming, but Netflix is amply rewarded for it, as it should be, because it has proved that it can deliver the goods (of course, the market should give a better outlook to the Mouse’s ecosystem, as there is still value to that paradigm, but I digress).
Still…is streaming the only business that should receive aggressive capital investment?
I’ve talked about advertising before, and that will be important to Netflix going forward, and certainly the World Wrestling Entertainment deal is driven by ads, but let me add a couple points to that particular thesis.
First, I wonder if Netflix might have the ability to show some commercials during the WWE content to no-advertising tiers considering it is a different kind of show. From what I have read, that won’t be the case, as only the ad-tier will be seeing them. But upon first showing, perhaps the company could make a case that there will be at least some advertising displayed because of the cost of acquiring the programming (said to be $5 billion over ten years) – I say first showing because I assume the shows will be archived and available on Netflix after the live broadcasts, but that is unclear to me at the moment. I would think the company would want to figure out some live-ad component to maximize value, especially considering I have seen in the past a few instances of ads being shown on a non-ad streaming service under the justification of a different set of rights for a specific program, but I concede that would probably complicate the deal with TKO Group (TKO) and make the structure more expensive.
Second, here is an interesting comment from the conference call, by co-CEO Greg Peters:
We want to launch more ads products. We’ve got binge ad sponsorships now. And we have to build increasingly the capability to be better partners with advertisers and serve their needs.”
Sponsorship advertising is something that fascinates me, because in theory, one could use it in a similar way as a platform such as public broadcasting (or even Disney Channel) uses it -just a quick mention at the beginning of a show or film, after the content begins to roll – even for non-ad tiers (whether there would be significant backlash on that or not, I do not know).
The binge advertising mentioned has a specific methodology which I found to be very clever – for ad-supported users, it gives the ability to score ad-free episodic content after watching ads in several previous episodes via a special sponsorship mention. Call it a gift for taking in the sponsorship (perhaps the non-ad tier users could be rewarded by receiving a QR code that sends a gift to the member in the form of a piece of collectible merchandise or a commerce coupon).
But all of that will evolve over time. Another thing to mention is the issue of the platform becoming a big player in the purchase of content from outside sources. And again, this is really funny in a sense because those looking to sell to Netflix, such as Disney and Comcast (CMCSA), previously feared doing so because it was felt the company was becoming too powerful and would obviously dominate with its buying power over time (i.e., be the primary bidder and set the price); this led to the creation of Hulu, with funding by competitors Disney et al., to create a new marketplace for content, the idea being it would set up the marketplace and then sell it (unfortunately, it found no bidders and Disney ended up paying Comcast for the perhaps questionable privilege of owning it today).
What’s interesting about this new development is that it helps everyone in Hollywood, including Netflix. Netflix can use licensed content to offer more material for its members, while the licensors take that monetization and help offset linear-ecosystem costs (as well as streaming costs, it almost goes without mentioning).
I’ve spoken before about how Netflix must invest in the theatrical business. Not only has my opinion not changed on that, it has only increased in terms of the need to do this. Management remains adamant: the theatrical business is of no interest at the moment.
Yet, it is of interest to me that, like Disney, which operates the El Capitan theater in Los Angeles, Netflix is actually the owner of its own prestige exhibition house, The Egyptian Theatre. The pandemic hampered plans for that asset, but it has been open since the fall of last year.
Make no mistake, this doesn’t represent the kind of jump into theatrical that I want as a shareholder, but if Netflix can see some value from the screens it owns (which also includes a theater in New York, the Paris Theatre), it may end up doing with theatrical what it did with advertising – namely, reverse course and invest in something it previously criticized as non-relevant.
Why should it distribute content in the multiplex? Two reasons: more revenue, cost amortization. For its smaller projects, it could recoup some costs while promoting the service. For bigger projects, Netflix could finally try to expand its financial horizons with blockbusters. Talent will certainly appreciate seeing its work in theaters, but that’s not my primary concern – money is. Netflix can hatch new intellectual properties that will bestow future benefits for shareholders; management should stop being resistant to this idea. The company could take the theaters it owns and start small, programming some of its episodic series in them for special events (Stranger Things would certainly come to mind, with something like a premiere episode and/or a finale appearing on the big screen ahead of the smaller one). Use the screening rooms to sell merchandise and advertise the service (maybe even allow people to sign up at the box-office counter). The synergistic models available would certainly be myriad and limited by imagination alone. And going back to talent for a moment, if you read my previous piece on the subject, Netflix could use multiplex releases to pay off its filmmakers with cuts of that sales stream as opposed to huge backend buyouts. I do not think, I should note, that Netflix necessarily needs to buy a theater chain, although a few more pieces of real estate (perhaps in conjunction with event spaces) might be an attractive proposition – more to the point, the company should set up a distribution system no different than any other media concerns with existing exhibitors.
Perhaps one final puzzle I’ll mention here is how much Netflix could gain from merchandising, which I believe the company needs to aggressively expand. And I’ll include in that the idea of selling physical releases of its products. Previously, I have argued the streamer should sell physical sets of its shows and movies simply as a business separate from any merchandising effort, but I don’t think the company wants to scale up to that point…instead, it will simply have to look at smaller-run releases as merchandise collectibles in and of themselves. To be clear, I am talking about IP that is fully owned, as there are Netflix shows on physical that are owned by others. But as far as toy sets and action figures and tee shirts and novelizations and all of that, there is room to expand here and replicate the Disney model. Consumer products generated about $2 billion in annual income for both fiscal 2022 and 2023 for Disney (page 47 of the annual report). This would not be a bad business to be in.
Conclusion/Valuation/Risks
As far as the valuation of the stock, it has become expensive, and not only fundamentally, but perhaps technically.
Still, my feelings on buying the stock haven’t changed much: Netflix is still growing, it’s a quality stock/story, and one can average in.
What has changed is the rise in price. That complicates things, perhaps. Those who want to take profits certainly won’t get hurt, but for me, I do want to maintain a long-term position (in addition to the shorter-term position I mentioned).
The SA valuation tool currently reads a D rating, although, as I always do, I like to separate that into two components – comparison to the relevant sector, and comparison to the stock itself.
If one compares valuation to the sector, yes, NFLX fails. And that’s important to consider, as the SA valuation system seems to give significant weight to it.
If you combine that with the 52-week range (one of my favorite metrics for long-term holdings), you definitely come up with an expensive reading.
We still need to think more about this, though, as I am still rating this a buy on pullbacks.
First, Netflix is a leader in its space, and if you are a long-term holder, you definitely have cause to both hold the shares and add on pullbacks.
Second, some of the comparisons to the stock itself read less expensive. On a five-year-average basis, the shares are 38% below (at time of writing) what NFLX has traded at in that past time frame in terms of forward adjusted P/E. The forward EV/EBITDA is close to 25% below. Price-to-cash-flow is 75% below, on a TTM basis. PEG, at 1.22 (again, at the moment), is attractive compared to the five-year-average, although I would like that to be closer to 1.0; still, compared to when I last wrote about the stock, when it was at 1.46, the PEG is not only better but has been upgraded by the valuation system to B- compared to C. Nevertheless, I could find other examples that don’t compare so well to the past average, I will concede. As an example, price/sales has risen. So has price/cash flow. However, the improved generation of cash flow over the years to me is a more important development.
But…let’s now add in the other ratings by the SA tool: growth, profitability, momentum, and revisions, the factor grades. All A’s and a B.
We seem to be in a bull mode for the stock market this year, but we will get downturns as one day indications from the Fed will go one way and on the next day they will go the opposite. You know the drill. That will affect Treasury rates and bond prices, and the market can easily sell off a growth stock like this one.
Because we are seemingly in a bull market overall, I’m not going to say I will wait for the stock to get back to the 52-week low…doesn’t seem like the prudent approach. Instead, I will look for sell-offs in which to add, and as I stated at the beginning, I will trade around the shares a bit while keeping my long-term position mostly intact (to remind the reader of what I stated at the beginning: I did trim out some of that position mostly to have cash available for other existing positions, as well as starting a few new ones).
To sum up on valuation: I haven’t evolved too far from my previous stance of dollar-cost-averaging for investors who want exposure to the top streamer. I don’t believe the company is done growing, but the higher price in the stock does mean that you will want have to cash available to take advantage of sudden drops (and yes, those are coming).
At some point the stock will become a hold for me, which I will define as a point where I will no longer add, or I will even begin to trim more aggressively. Here’s a chart of the stock price:
That spike in price near the $700 level around late 2021 defines an area around where I would have to reassess the stock. We’re a long way off from that, obviously, but another level to look at for those who may not want to hold for that long would be the $600 level, which some technical pundits have mentioned. I myself would not be looking to necessarily sell at that level in terms of a long-term position as I would prefer to let one in Netflix continue to ride; sometimes round numbers with zeroes tend to trigger sales, hence such a technical call. The key between a hold and a sell would be a significant change to the overall thesis that somehow causes the company to shed subscribers at an alarming rate. Another point for many to consider would be if a stock was overvalued on just about every metric and growth factor grades were on the decline. Again, we are not there yet, but it is worth mentioning and thinking about where and why an investor or trader would need to consider an exit. I will add that if the stock starts to rise close to the 2.0 level on forward adjusted PEG, then it will be beyond fair value for me.
Adding all this together – the long-term potential, what I imagine the company will do in the future in terms of adjusting strategies, the factor-grade ratings, the valuation compared to the five-year averages on some of the metrics (while respecting the averages that don’t compare well) – I am calling this a long-term on pullbacks, averaging in more aggressively as the share price drops during volatile times and not-so-aggressively until the next technical breakout.
There are risks, though.
First, overall market volatility as mentioned.
Second, don’t think Netflix can’t suddenly have a bad streak of content releases – and by that I mean, the content is not received well and growth in subscriber count either stalls or declines (know well that just one quarterly report of declining subscriber growth could send the stock tumbling).
Third, I see as a risk the absence of innovation on Netflix’s part. For instance, if the company does not eventually get into theatrical releases (as I have discussed prior) then that will mean the company does not necessarily believe in building out an ecosystem beyond streaming. It can’t be that way forever; as I have stated, Netflix, if it truly is now the winner of the streaming wars, will need to disrupt itself before others do so.
Fourth, Disney et al. may figure out some new approach to streaming that hurts Netflix. The industry may make some consolidation move that scales up competition and bring a challenge to the big streamer’s business model.
Lastly, valuation may trump other positive factor grades in the eyes of institutional investors that may impact their sponsorship of the stock.
Consider all the positives and negatives to the story before buying…
