Stockwatch: Netflix could become a classic Buffett ‘franchise’ stock

by Edmond Jackson from interactive investor |

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Consumer loyalty to online streaming platform could see it achieve next-level investing status.

Last July, I cited inherent risks with “a fundamentally stretched valuation” of Nasdaq-listed Netflix (NASDAQ:NFLX). At $527 (£402.2) its capitalisation was $232 billion implying 8x to 9x expected 2020 sales.

I wrote: “Such a market value leaves no room for any deterioration in the story, while the chart implies scope for pull-back to $460”.

Yet the stock tested $560 both in July and September before running into an inevitable setback with this week’s third-quarter results. It is a good example of how the Americans’ emphasis on quarterly reporting means they get het up if reality dashes expectations. But it is best to sit back and take a measured view.

The share price slid to $485 after the numbers varied somewhat from guidance as well as expectations, and a slowing in subscriber growth hurt sentiment. This appears to be at the lower end of an upwards trend-line. Chartists might see further weakness as a breakdown. 

New subscribers seen as the main issue

Around 2.2 million were achieved, versus guidance for 2.5 million, although FactSet had cited expectations for 3.6 million. It compares with 10.1 million in the second quarter after a 15.8 million spike in the first – implying a global dash in March, to fix lockdown entertainment. Such exceptional circumstances mean it was always going to be tricky to anticipate where demand might settle. 

In the earnings call, management stressed “a giant pull-forward in subscriber additions in the first half of the year…is super, super difficult to forecast…but the general underlying metrics are very healthy”.

Retention was said to be at better levels than a year ago, and customer acquisition remains strong. Fourth-quarter figures will tell, obviously.

Figures were otherwise a bit of a jumble. Guidance had been for $1.25 billion operating profit on $6.33 billion revenue, with net income around $954 million translating into earnings per share (EPS) of $2.1. The outcome was a 1.7% beat for revenue of $6.44 billion and a 5.6% beat for operating profit of $1.32 billion. However, net profit was a substantial 17.2% shortfall while EPS missed only by 1.7%.

Since customer numbers were awry, worriers were liable to latch on to this rude profit drop.

Additionally, the rate of year-on-year revenue growth is in a declining trend from 31.1% in the third quarter of 2019 to 22.7% in Q3 2020. 

The earnings call cited potential price increases, which might meet resistance from powerful telecoms groups offering Netflix bundled with their own consumer contracts. 

If they are strong enough to keep Netflix’s demands in check then there may be less scope to raise prices generally. For example, my mobile contract is with my broadband provider, which mobile rivals cannot match.

Fourth-quarter guidance matches analysts’ expectations for $6.58 billion revenue although EPS of $1.35 would outstrip this by 44%. Personally, I think this says more about the trappings of quarterly reporting than it does about value. 

Positive free cash flow is expected to grow, longer term

This has the semblance of a more definite trend: a third consecutive quarter of positive free cash flow totalling $2.2 billion this year, versus $1.6 billion absorbed in the first nine months of 2019.

Around $1.3 billion net cash was in the third quarter alone versus $502 million absorbed, like for like. However, this is also tricky to interpret given cash-absorbing productions were compromised by lockdown. So, as they increasingly resume, fourth-quarter free cash flow is guided to be slightly negative.

Looking further out, the company expects “our free cash flow profile over the coming years to continue to improve, as we increase our profitability and our transition to producing Netflix originals matures”. 

At the end of September, the business was well-supported by $8.4 billion, plus a $750 million credit facility.

Netflix Inc - third quarter 2020 results              
$ millions              
  Q3 2019 Q4 2019 Q1 2020 Q2 2020 Q3 2020 Q3 2020 Q4 2020
          forecast   forecast
Revenue 5,245 5,467 5,768 6,148 6,327 6,436 6,572
Year on Year % growth 31.1% 30.6% 27.6% 24.9% 20.6% 22.7% 20.2%
Operating income 980 459 958 1,358 1,245 1,315 885
Operating margin 18.7% 8.4% 16.6% 22.1% 19.7% 20.4% 13.5%
Net income 665 587 709 720 954 790 615
Diluted EPS 1.47 1.30 1.57 1.59 2.09 1.74 1.35
               
Global Streaming paid memberships 158.33 167.09 182.86 192.95 195.45 195.15 201.15
Year on Year % growth 21.4% 20.0% 22.8% 27.3% 23.4% 23.3% 20.4%
Global Streaming paid net additions 6.77 8.76 15.77 10.09 2.50 2.2 6.0
               
Net cash generated in operations -502 -1,462 260 1,041   1,264  
Free cash flow -551 -1,670 162 899   1,145  
Adjusted EBITDA 1,107 586 1,084 1,489   1,450  
Shares in issue 451.6 451.4 452.5 453.9   455.1  

Source: Company REFS

How Netflix gains ‘franchise’ credentials 

Those long of Netflix can at least entertain a potential sweet spot where free cash flow builds materially alongside compelling content creation. You would then be holding the kind of stock Warren Buffett has idealised as a franchise – which has nothing to do with setting up shops under an established format. Instead, he means enduring consumer loyalty to products and services that throw off cash. 

I will not backtrack on my inherent caution. Netflix remains exposed to any general shift in investor preference – say towards value/cyclical stocks and away from highly priced growth.

It is still very early days to figure when, and what magnitude, such a tipping point to consistent cash generation would involve. Moreover, on circa 80x earnings, unless earnings massively re-rate then Netflix’s valuation is not going to enable any meaningful yield – even if free cash flow does ramp up. 

But these results and their narrative do at least show Netflix is pretty well underwritten for its evolution towards a self-funding programme maker and global content distributor. This would be an enviable commercial position and the stock would sustain a premium value.  

Market price reflects such a tussle of sentiment

The stock appears likely to remain volatile as its results have involved contrasts. Bulls can take heart, as their long-term rationale is reinforced by the sight of free cash flow raring, even if transiently. Meanwhile, bears are left mulling revenue and subscriber numbers.

The near term is thus tricky to call, but any potential buyer should properly await a chart support point to establish. Until intrinsic value is substantiated, chartists may well have greater influence on sentiment. 

Also yet to be resolved is the macro asset allocation call between growth or value stocks. Has growth become an overcrowded, overpriced trade, now exposed to switching? Or one whose time very much remains, given central banks have destroyed interest rates? 

Even when low rates apply, the sense is growth stocks’ future soaring cash flows being rated more highly than traditional industry stocks. Nowadays, rates are zilch and many central bankers are even entertaining negative rates.

Is mean-reversion becoming less likely now? 

My avoid stance in July was based chiefly on the growth trade (Netflix being a prime example) hitting an inflection point. Since then, at least two investment banks have recommended clients shift into value/cyclical stocks, ahead of a now-expected Democrat victory in November to pave the way for extra US government stimulus. 

Meanwhile, the Federal Reserve chairman appears to have resumed whatever it takes messaging, where keeping interest rates hammered down implicitly sustains the growth trade.  

In conclusion, you could say both the top down and bottom-up, i.e. company specific, messages involve contradictions. Nevertheless, I like the way Netflix’s proof of cash flow strength reinforces its potential to become a franchise stock, according to how programming strengths play out. 

The stock is fundamentally overpriced, but I think unlikely to attract short sellers unless its future results reinforce concerns about revenue. Top line growth is often seen as the real proof of a growth company. 

Should markets sell off in reaction to shock events, a dilemma with fresh money is that Netflix might not become attractively oversold now it has proven its credentials for this pandemic era. 

Nonetheless, my emphasising a risk of mean reversion was possibly jaundiced. Equities may well remain a financial asset of choice, hence buy the drops attitude. This includes growth stocks. 

I could be premature in upgrading from avoid until a sustainable revenue growth rate is established. With fresh money I would continue to steer clear, but think there are reasons for holders to take encouragement from these results. Hold.  

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

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