Interactive Investor

Stockwatch: will Willy Wonka make Netflix shareholders rich?

22nd October 2021 12:30

Edmond Jackson from interactive investor

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After Netflix shares hit a record high soon after recent Q3 results, our companies analyst gives his opinion and what to make of the bullish consensus. 

Investors have been unsure what to make of third-quarter results from streaming services stock Netflix (NASDAQ:NFLX). Initially, it edged over $640 in response to claims of “trouncing” expectations which seemed odd to me given the release seemed overall mixed.

I was struck by a sense of bias, of how analysts on US financial TV came across as cheerleaders; one in particular wearing a bold Netflix top. Perhaps such an overt sign of being in love helps explain why the trailing price/earnings (PE) multiple is well into the 50s.

The price then dropped to near $620 but jumped yesterday to $653 on no fresh news. 

Differences between technical and fundamentals’ views   

A chartist might say this is modest volatility after a 25% rally since springtime – and considering a very strong run from around $12 over a decade or so. 2018 to 2020 saw much greater volatility, sideways, which proved to form a base for the next strong advance from $300. 

A prominent US commentator said mid-week, it has always paid to buy the drops in Netflix – so do it again – and the price duly rallied. This perfectly illustrates “inductive reasoning” like the happy pig which assumes the sight of the farmer each morning means food, until one day it is slaughtered. 

On fundamentals, I see a conflict in take-away observations on these results. It is possible to fret about how Netflix looks to be approaching maturity in terms of subscribers in the US and Canada; how growth there will certainly require prices to be raised. Off-setting this to help overall 16% revenue growth is a solid increase in Asia-Pacific subscriptions and, some would say, the phenomenal success of Squid Game. The South Korean survival drama has, in a month, become Netflix’s biggest-ever TV show with 142 million households watching it globally. It shows capability to leverage a localised culture globally.

No margin of safety, or scope for disappointments

The nub, however, is Netflix easing from its years of 20%-plus revenue growth to rely on price increases and attracting a much wider global audience, both of which are speculative. You have to take a view. Meanwhile, the stock is on a big rating with no scope for disappointments. 

A year ago, at $485 and last July at $514, I applied “hold” ratings – wary of downside risk in the valuation, especially if enthusiasm for growth stocks wanes, but respecting a long-term international brand par excellence might be taking shape. Call that a fudge but sometimes it is up to individual investors to decide their risk appetite, relative to that which an analyst objectively prospects. When valuations run high, you are significantly also trying to guess: how long can this party last? 

After a 27% advance to $653 in barely three months, you also have to ask: was market pricing wrong then or now?

Amid claims of beating expectations the numbers need unpicking

While 16% revenue growth to $7.5 billion (£5.4 billion) was in line with expectations, growth doubled in additional net paid subscribers to 4.4 million, taking group total to 214 million. This beat consensus for 3.8 million and can be seen as a proxy for future revenue.

Bulls have alighted on this as their new rationale. It affirms how Netflix is finding new customers globally despite possible saturation in the US and Canada, also as strong fresh content becomes available after Covid compromised production. 

Management guides for 8.5 million new subscribers in the fourth quarter, although like-for-like that will be flat and the operating margin will be lower – said due to higher amortisation charges on news content, albeit which I would assume can be “normalised” and must also involve production costs. A minimum 20% operating margin is guided for the full year, which is good, although it’s unclear quite whether that will be good enough to justify the stock rating.

Notice a strong element of operational gearing, with operating profit soaring 33% to $1.8 billion and earnings per share (EP) of $3.19, well ahead of the $2.56 expected. I respect that if Netflix impresses an increasingly global audience in years ahead, it can leverage profit. Bulls already proclaim: “a revenue growth story becoming a profits story.” 

Free cash flow (FCF) has varied remarkably quarter to quarter, according to production starts and spending on (acquiring) content. But another element to the bull case is a FCF turning point: management guides for roughly break-even for 2021 as a whole - despite $410 million having been generated in the year to date – then Netflix to be free cash flow positive in 2022 and beyond.

Can Netflix proceed to steadily inflate subscriptions?

This to me is the crux. The third-quarter numbers show revenue growth driven by circa 10% increases in average revenue per membership in the US and Canada, as the 2021 quarters have evolved, albeit stuck at this level with membership bumping along at around 74 million. 

Meanwhile, in Europe, the Middle East and Africa, average revenue per membership has eased from 11% to 7% in the third quarter. Latin America shows a jump to 8%, year-on-year, though in Asia-Pacific it has declined from 9% to 4% and, taking account of currency translation to the US dollar, it has been just 1%.

Is Netflix is running into a challenge to materially raise subscriptions, especially as loose monetary policy unwinds and people spend more on going out? Or do movies-on-demand at home still represent compelling value versus going out to cinemas? Possibly, Netflix will benefit from higher inflation affecting ticket prices.

It seems too tricky to make a call on such variables as to how popular Netflix’s content will prove, and at what price points. But of one thing I am sure: on a trailing PE over 50x you have to be confident the business can deliver pretty exceptional growth, to bring that multiple down on a forward basis. 

Otherwise, the stock rating has to mean revert at some point. Current buyers are playing a game of pass the parcel.

Netflix, Inc: second-quarter results
$ millions

  Q3 2020 Q4 2020 Q1 2021 Q2 2021 Q3 2021
Revenue 6,436 6,644 7,163 7,342 7,483
Year on Year % growth 22.7% 21.50% 24.20% 19.4% 16.3%
Operating income 1,315 954 1,960 1,848 1,755
Operating margin 20.4% 14.4% 27.4% 25.2% 23.5%
Net income 790 542 1,707 1,353 1,449
Diluted EPS 1.74 1.19 3.75 2.97 3.19
           
Global Streaming paid memberships 195.15 203.66 207.64 209.18 213.56
Year on Year % growth 23.3% 21.9% 13.6% 8.4% 9.4%
Global Streaming paid net additions 2.20 8.51 3.98 1.54 4.38
           
Net cash generated in operations 1,264 -138 777 -64 82
Free cash flow 1,145 -284 692 -175 -106
Shares in issue 455.1 455.3 455.6 455.1 454.9

Source: Netflix, Inc

A major slate of fresh content should boost fourth quarter

The current quarter is promised to be the strongest yet for content, albeit with the expense tempering margins. “We have so much coming like we’ve never had…and it rolls into a great next year also.” Acquiring the Roald Dahl Story Company offers scope to develop compelling new dramas, both film and animated.

Mind, that a relatively normal slate of content is anticipate for 2022, with a greater number of originals and a more balanced release schedule. Competition continues to evolve and Disney Plus has similarly run into growth challenges.

I am apt to concede Netflix stock may remain quite a voting machine – in due course, on popularity of Willy Wonka films when they appear. Currently, it looks very hard to buck the stock chart, which has risen again after initial doubts on the latest figures.

Should you accept a near-universally bullish consensus?

Pretty much everyone in the investing community persists to talk Netflix up, which I see as symptomatic of a mature bull market helped by loose-money policies.

My sense is it being premature to assert “sell”. That might come after a buoyant fourth quarter. But you would not want to get caught in any rush. For now, warily: Hold

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

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