Netflix Stock: Time To Move On From Membership Metrics (NASDAQ:NFLX)

Investment Thesis

In my last article on Netflix (NASDAQ:NFLX), published in October 2023, I argued why the company’s strategy of price increases and an increased push towards animated movies showcased its ability to grow even during a challenging environment. I upgraded my rating from a HOLD to a BUY at the time. Since my article was published, the stock has gained nearly 37%, comfortably beating the S&P 500, which rose 19.5%.

In this article, I discuss the company’s Q1 numbers and argue why investors should focus less on the company’s decision to stop reporting quarterly membership guidance and more on the company’s deal with the WWE, as the latter offers multiple levers of growth.

A Snapshot of Netflix Q1 Earnings

Netflix has made a strong start to the year. Q1 revenues came in at $9.37 billion, up 14.8% y/y, and beating analyst estimates by $91.6 million. Diluted EPS came in at $5.28 for the quarter, up a whopping 83% y/y, and comfortably beating analyst estimates by $0.74. The company also saw strong membership growth, with global streaming paid net additions coming in at 9.33 million, more than quadrupling y/y. Paid net additions, to offer context, during Q1 of FY23 were 1.75 million. The company also generated operating margins of 28.1% and, despite heavy content spend, generated free cash flows of $2.14 billion.

Management provided upbeat guidance as well. The company now sees FY24 revenue growth of 13 to 15% and FY24 operating margins to come in at 25%. Paid net additions for Q2, however, are expected to be lower sequentially on account of seasonality.

Netflix Will Stop Reporting Quarterly Membership Numbers from FY25. So What?

One of the main reasons why, despite a stellar quarter, NFLX’s stock tanked post the earnings release was the company’s announcement that they will stop reporting quarterly membership numbers and Average Revenue per Member metrics from the first quarter of FY25. This is a follow-up to the company’s prior decision to stop offering quarterly paid membership guidance from 2023. Instead, management plans to offer annual revenue guidance on top of what it usually provides: guidance on annual operating margins and free cash flow forecasts.

The Street appears to have interpreted this as a sign that NFLX is evolving from a high-growth, low-profit company to a slow-growth, high-profit company. It also appears to have interpreted this as a red flag, given how much importance it has placed on NFLX’s paid membership figures. The stock, following the earnings release, tanked 9%, and the decision to discontinue guidance on membership numbers was one of the primary factors behind the move.

In my opinion, the market reaction to this announcement has been overdone. This is because I believe that NFLX management’s rationale behind the decision makes perfect sense. NFLX no longer has a uniform pricing strategy and has no longer a single membership plan. With the arrival of ad-based plans, the membership plans have evolved from a single tier to multiple tiers. The company has different price points for each country, all of which, according to management, “has a very different business impact.” Therefore, announcing quarterly membership numbers can get trickier. As the platform evolves even more, especially if it ventures into categories such as live sports more widely, then there is a possibility that it could introduce features such as pay-per-view packages for one-off events, which could make the process of reporting membership figures challenging.

What I am more focused on is engagement, especially if the pay-per-view packages become a reality. The company has been offering engagement metrics more prominently, such as the Top 10 Weekly Lists by region and “The Most Popular” category. And the engagement metrics offer more insight into whether NFLX is spending on content wisely. For instance, investors should be more enthused that its latest shows such as Avatar: The Last Airbender, Griselda, and Fool Me Once have been successful, garnering more than 60 million views each during the first quarter. And given that the company plans to scale up advertising in the coming months, engagement metrics would also offer investors more insight into whether advertisers would remain interested in spending on NFLX.

Finally, NFLX is on top of the game right now. Disney CEO Bob Iger, in an interview last month, said, “The gold standard there is Netflix. We need to be at their level in terms of technology capability.” It is not every day that the Number 2 player acknowledges that they are nowhere close to the Number 1 player. NFLX is playing on a level that is above its competitors, in my opinion, and is living up to its potential with solid numbers. And despite continuing to spend heavily on content, churning out new movies and shows, the company still managed to rack up $2 billion in free cash flows. Therefore, it is time, in my opinion, that we view NFLX with a different lens. This is a company that has figured out how to make money, even during the age of streaming wars. As such, it doesn’t matter that it is not going to offer membership numbers. The company has evolved from that stage, in my opinion. So should investors.

WWE Deal, the Perfect Catalyst for NFLX’s Advertising Business

At this point, everyone, including NFLX’s management, is excited about the upcoming Jake Paul-Mike Tyson fight, which is going to be streamed live on Netflix, as the company ramps up its live sports offerings. I, however, am more excited about the company’s ten-year deal with the World Wrestling Entertainment (WWE), whereby from January 2025, NFLX would be streaming WWE’s Monday Night RAW every week on the platform. The deal, which was signed back in January, is reportedly valued at over $5 billion. Furthermore, as part of the package, Netflix will also be streaming WWE’s Smackdown and NXT, as well as the company’s Premium Live Events, including WrestleMania, SummerSlam, and Royal Rumble, outside the United States.

The deal with WWE presents a huge catalyst for NFLX’s future growth. First, Monday Night RAW, which is currently the No. 1 show on the USA Network, has been one of the “longest-running weekly episodic sports television shows in the world.” As such, it offers NFLX with an opportunity to acquire more subscribers, given the show’s history and the fan following. Second, while the company would initially start streaming the live show in the US, Canada, the UK, and Latin America, it has the option to roll it out to other regions throughout the life of the contract. This means that the company could further expand in regions such as India, where WWE is extremely popular, thereby boosting its presence in the world’s most populous nation. Both LATAM and APAC regions, during the first quarter, saw their Average Revenue per Member (ARM) decline 4% and 8% y/y, respectively (on a currency-neutral basis), which suggests that there is some form of slowdown there. The deal with WWE could provide the impetus for future growth in these regions in the future.

Finally, one of NFLX’s plans is to scale up the ads business. More specifically, the company aims to scale ads to make it a “more meaningful contributor to our business in FY25 and beyond.” The company is already seeing steady growth in its ads membership, which grew 65% sequentially during the first quarter, after rising nearly 70% q/q in both the third and fourth quarters of FY23. However, from an ad business perspective, the company is still very much in the early innings. This is why the deal with WWE offers a perfect opportunity. Given that Monday Night RAW does not arrive until January 2025, there is plenty of time for NFLX to build out its ad business and fine-tune it so that they can capitalize on the opportunity from next year. Moreover, since the deal with the WWE is a multi-year deal, it’s an opportunity for the company to generate steady revenue from advertisements. It also offers advertisers some form of stability, which should allow NFLX to attract more advertisers.

Live sports & entertainment are a much better venue for advertisements, compared to TV shows and movies. The deal with WWE, therefore, offers NFLX with a new source of revenue growth.

Valuation

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Source: LSEG Workspace (formerly Refinitiv), Seeking Alpha, Author’s Projections, and Company’s Q1FY24 Letter to Shareholders

As mentioned earlier, the company now expects FY24 revenues to grow 13 to 15% y/y. Assuming the midpoint of the guidance, this would translate to FY24 revenues of $38.44 billion. Management now expects FY24 operating margins to be 25%, which results in an operating income of $9.61 billion.

I have assumed non-operating expenses for the company at $680 million, the average value of these expenses over the last five years. I have assumed the effective tax rate to be 13.5%, which is the industry median, according to LSEG workspace (formerly Refinitiv). Taken together, this would translate to FY24 Net Income of $7.72 billion. According to LSEG Workspace (formerly Refinitiv), the number of shares outstanding, in free float, now stands at 427.71 million. This translates to an FY24 EPS of $18.05. This implies an EPS growth of 50% y/y, which is in line with LSEG Workspace’s estimate (53%).

The company, according to LSEG Workspace (formerly Refinitiv) currently trades at a forward P/E of 28.9x, which is in line with its historical 2-year median value. Although the multiple is lower than its historical 5-year median value of 44x, NFLX is no longer the kind of hyper-growth company in my opinion. It’s a company that’s evolving into a steady growth company that focuses more on profitability rather than “growth at all costs.” At the same time, given its leadership status and the various new revenue opportunities that it’s pursuing, the company does command a much higher multiple than the industry median of 16.5x. As such, I have assumed a forward P/E of 28.9x for my calculations.

The company, according to Seeking Alpha, has a forward PEG ratio of 1.05, which suggests an EPS growth rate of 27.5%. This results in an FY25 EPS of $23.01. At a forward P/E of 28.9x and an FY25 EPS of $23.01, we get a price target of about $665, which represents an upside of approximately 20% from current levels.

My valuation for NFLX has changed since my last article for three main reasons. First, despite assuming a lower P/E multiple (28.9x vs. 33x), I have assumed a higher earnings growth since my last article (27.5% vs. 25%), taking into account the new opportunities such as its deal with WWE, and its intention to scale up its ads business. Furthermore, I am basing my valuation on FY25 EPS, compared to FY24 EPS. Finally, I have boosted my expectations for FY24 EPS, given the strong membership growth and the positive engagement with NFLX’s content. My rating for the company has remained the same since my last article.

Risk Factors

The major risk factor to my thesis is that the deal with the WWE falls short of expectations, which could be a major problem both for its live sports ambitions as well as for its advertising business. I have adopted a conservative estimate of 27% EPS growth for FY25, given that I would expect the company to invest heavily to scale up its ads business ahead of streaming Monday Night RAW. However, there is the risk that the strategy could fall short of expectations, either due to glitches or due to failing to attract more subscribers.

Moreover, NFLX may be the king of the hill, but its competitors are fast catching up. After a bruising proxy fight, Bob Iger is firmly in the driver’s seat at Disney and has plans to ramp up Disney+. The streaming service is expected to be profitable by the end of FY24, and Disney has also inked a deal with Warner Bros. Discovery and Fox for live sports streaming, which could provide tough competition to NFLX’s live sports segment.

Finally, as I mentioned last time I wrote about NFLX, there’s the company’s ad business, which the company is still trying to figure out. While WWE should provide a much-needed impetus to the ads business, whether advertisers would be convinced to stay with NFLX remains to be seen.

Concluding Thoughts

NFLX had a strong start to the year, beating on both the top and bottom lines during the first quarter. The company’s content has been a hit with subscribers, and the company is continuing to extend its leadership, as evidenced by the strong growth seen in paid net memberships. This makes the investor reaction to the company’s announcement to stop offering quarterly membership numbers all the more baffling.

The company’s ten-year deal with the WWE and its newfound focus on live sports programming is what investors need to focus on, as it not only offers a new source of revenue stream but also provides a perfect catalyst for the company’s advertisement business.

NFLX is evolving and has already moved past the stage where membership growth was the catalyst. It is generating strong margins and free cash flows, despite continuing to invest heavily in content. As the company shifts its focus towards new levers of growth, so should investors. Content, not membership metrics, is king.