Interactive Investor

Stockwatch: can you buy Netflix shares on the cheap?

23rd July 2021 09:38

Edmond Jackson from interactive investor

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Our columnist digs into the merits of the world’s biggest streaming service to work out whether its valuation stacks up now.

Shares in Netflix Inc (NASDAQ:NFLX) eased about 4% in response to mixed second-quarter 2021 results – beating revenue and subscriber expectations but falling short on earnings per share (EPS). 

Around $514 currently, the stock price capitalises the entertainment streaming giant at around $226 billion (£165 billion), or a colossal 9x $25 billion underlying revenue last year.

By way of growth stock comparison, the trailing price/sales ratio for Amazon (NASDAQ:AMZN) is 4.3x and 1.6x for media group News Corporation (NASDAQ:NWS), which is capitalised at just over $14 billion, fluctuating between profit and loss on circa $10 billion revenue. 

Netflix’s historic price/earnings (PE) is around 64x, albeit easing to 40x on the basis of around $4.4 billion net income for this year.

There is no dividend given cash flow is consumed for content development, although management has guided annual free cash flow at break-even – having no further need to raise capital for ongoing operations. 

It is hard to find another international growth stock that has capitalised on the pandemic so well; whose adoption may next leverage its success from domestic screens to mobile devices. 

Quite a no man’s land’ for the stock currently 

Yet it remains a big valuation on those fundamentals, and the chart implies enough investors are balking at it. For the last nine months, Netflix has been in another consolidation range - $480 to $565 – compared with $285 to $390 over 2018-19.

The stock took a major leg up when the first wave of Covid forced people stuck at home to reach out for entertainment; this providing a major new element to the Netflix growth story. 

Cash flows might eventually mature for dividends besides content development, but to offer a worthwhile percentage yield the stock would need to de-rate.  

This stock is therefore very much a confidence situation, of shareholders continuing to believe in long-term supernormal growth. Updates are scoured by bear traders for the slightest sign of faltering momentum, although the same applied to Amazon.com in its earlier years. 

It means a bit of a no-man’s land currently: updates cannot generate anywhere near the kind of impetus like a year ago; disciplined investors see no margin of safety; and traders recognise no definitive trend in the stock either way. 

Respectable Q2 with ongoing new subscriber growth 

Despite tough comparators, second-quarter 2021 revenue rose 19% to $7.34 billion, slightly ahead of market expectations. 

There was also a beat for global subscribers, up 1.54 million versus 1.0 million anticipated, for a total over 209 million. A number of 3.5 million is projected for the third quarter versus 2.2 million like-for-like. Netflix says: “Covid has created some lumpiness in our membership growth – higher in 2020, slower this year – which is working its way through.”

Acquisition and engagement of households was down on unprecedented levels during the early stage of the pandemic, but still up 17% on the second quarter of 2019. Member retention is strong and ahead of 2019. 

A key question is whether Netflix can raise prices for this new wave of subscribers since Covid: retention is so far strong and better than pre-Covid levels, despite average revenue per member rising 8% over a two-year period. 

Revenue is therefore being driven by this plus an 11% rise in average paid streaming memberships, although 11% has benefited from currency translation (recently weaker dollar alongside Netflix’s international growth). Otherwise, it would have been 4%.

Normalising for currency, average revenue per member is projected to grow around 5% year-on-year in the third quarter. 

20% annual operating margin albeit an earnings miss 

A strong second-quarter operating margin of 25.2% rose 3% like-for-like, but is targeted to moderate to 20% for the year as a whole, versus 18% in 2020.  

Netflix said: “After our global launch in January 2016, we are committed to grow our operating margin at about 3% over any few-year period…assuming we achieve this year’s target we will have quintupled our operating margin in the last five years.” 

Diluted EPS of $2.97 soared 87% on $1.59 a year ago, despite a $63 million loss from currency measurement of euro-denominated debt. But it came well short of management’s guidance for $3.16 and possibly this was a key reason sellers prevailed. 

Net cash from operations slumped to $64 million absorbed versus $1 billion generated, like-for-like; sliding to $175 million absorbed in terms of free cash flow (after capital expenditure) versus $899 million generated like-for-like.

However, the second-quarter 2020 boost was due to Covid-related production shutdowns, and management is confident it is over a free cash flow and funding dilemma for day-to-day operations.   

Netflix Inc: second-quarter results
$ millions

  Q1 2020 Q2 2020 Q3 2020 Q4 2020 Q1 2021 Q2 2021
Revenue 5,768 6,148 6,436 6,644 7,163 7,342
Year-on-year % growth 27.6% 24.9% 22.7% 21.50% 24.20% 19.4%
Operating income 958 1,358 1,315 954 1,960 1,848
Operating margin 16.6% 22.1% 20.4% 14.4% 27.4% 25.2%
Net income 709 720 790 542 1,707 1,353
Diluted EPS 1.57 1.59 1.74 1.19 3.75 2.97
             
Global streaming paid memberships 182.86 192.95 195.15 203.66 207.64 209.18
Year-on-year % growth 22.8% 27.3% 23.3% 21.9% 13.6% 8.4%
Global streaming paid net additions 15.77 10.09 2.20 8.51 3.98 1.54
             
Net cash generated in operations 260 1,041 1,264 -138 777 -64
Free cash flow 162 899 1,145 -284 692 -175
Shares in issue 452.5 453.9 455.1 455.3 455.6 455.1

Source: Netflix, Inc

Goal to be a first consumer choice for entertainment 

As someone who is no film buff – or much fan of indoor entertainment at all, at least from modern media – I am in a weak position to judge beyond what I hear families (typically) say about Netflix. But it seems to have achieved mainstream parlance, and parents will presumably weather price rises over kids' tantrums. 

Programming has diversified substantially since a first original scripted TV series was launched in 2012.

Management seeks to achieve a first-choice status based on variety and quality of titles: for example, Shadow and Bone, based on the popular Grishaverse book series, has attracted 55 million member-households; and Sweet Tooth, based on a popular comic, 60 million households in its first four weeks. 

Expansion into non-fiction continues, such as season two of the Too Hot to Handle dating show which has gained 29 million households, and The Circle with 14 million, both in their first month.  

Only last week, Netflix series and specials received 129 Emmy nominations.  

My sense is that cinemas are going to suffer an aspect of permanent attrition, since the pandemic has changed behaviour and homeowners spent more on improvements.

The crux seems to be whether Netflix can gain more exclusivity for new film releases and the like, to advance a bandwagon effect towards its brand. For example, nearly a year has passed since it signed a deal with the Duke and Duchess of Sussex, although only two series have been announced.   

Yet it is still early days in the transition to on-demand entertainment: streaming represents just 27% of US TV screen time versus 63% for linear TV, on which basis Netflix is estimated to represent just 7% of US TV screen time.

It is even less mature in other countries, and this excludes mobile screens, all of which adds credibility to management saying “we are confident we have a long runway for growth”.   

Take your view as to the longer-term outcome 

My view of Netflix is compromised because it is not the kind of content I would watch. The stock’s humungous valuation also puts it off-limits if capital protection is a first priority, should markets slide. 

But as a stock analyst I respect a parallel with earlier years of Amazon.com, which was criticised and sold short at times, for earnings lagging a big valuation. 

The stock is significantly a call on Netflix’s long-term creative capability but, if sustained, then it will become a 21st-century brand par excellence. For those appreciating the risks, buy what drops, broadly: Hold.   

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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