Netflix Stock: Why We’re Staying Away (NASDAQ:NFLX)
We’ve always had a bit of a problem with Netflix’s (NFLX) business model. The company generates very little free cash flow and arguably has a pretty thin moat in the streaming business (especially as some well-capitalized competitors enter the space). The company just spends a huge amount of money on content and, unlike other names in tech, has to fund its growth with debt on the balance sheet.
Netflix is the only FAANMG I’ve ever owned.
Still, I’m understandably open to digging in and seeing what it looks like today, especially after Friday’s selloff (down 20% as I write this). Given the maturation of the business and its ability to continue to scale and grow its margins (and free cash flow), we thought this might start to look interesting. I did not buy Amazon (NASDAQ:AMZN) until the business model proves itself (at $1,800 more or less), then maybe we have a chance here with NFLX.
Here is a summary table of the quarterly letter to investors:
Investors were disappointed by two things. First, net subscribers missed Q4 expectations a bit, and forecasts indicate that additions will slow to 2.5mm in Q1 2022, from an expectation of 6.5mm.
Second, operating margins appear to be shrinking.
First, here are the net subscriber additions (from the same letter to investors):
2020 was a banner year, of course, with pandemic lockdowns helping subscriber growth. 2021 has dropped from the numbers in 2018 and 2019, and arguably if you average the number of additions in 2020 and 2021 you get pretty close to what they did in 2018 and 2019 (25mm plus or less).
But 2022 seems to be off to a bad start, as you can see above in red.
The impact on margins is surprising:
To meet 2023 and 2024 Street expectations, Netflix must grow operating margins from 19-20% today to 27.8% (calendar year 2024). Even if the company resumes a path of increasing EBITDA margins by 3% per year after a flat 2022, they will be lower than the 2024 estimates. In the best case scenario, an EBITDA margin of 26% is likely in our opinion.
Free movement of capital
Here is the latest cash flow statement.
We have highlighted the relevant items above in yellow. From an accounting perspective, companies in this industry spend money creating content (their biggest cost) and then spend quite quickly (depreciating content assets).
These amortization expenses go through the income statement, and the content costs are accounted for by the operating cash flow part of the cash flow statement (and not by the investing activities). Reported EBITDA is actually after content cost amortization (but not adjusted for actual content spend).
From the top, the business tends to spend a lot more than it amortizes on content (luckily at DISCK it’s about even, so EBITDA is a good measure of free cash flow with no effect leverage before investments and working capital).
While it makes sense to spend a little less than they spend (content libraries are valuable in years to come), we’ve always been concerned that these differences are quite significant at Netflix.
In 2020, FCF finally turned NFLX positive, but likely because content spending was delayed due to Covid. These expenses have clearly returned in 2021 (pushing the company back into negative free cash flow territory).
Even the average of 2020 and 2021 is not a lot of money available, around $900 million per year. If the excess of spent content over amortization count is 100% growth (and presumably includes a lot of growth), then we get $10.84 in FCF per share (quite close to $10.75 EPS excluding earnings in 2021).
At $400 per share, that puts NFLX at a yield of 2.7% FCF, or 37 times TTM cash earnings.
law of large numbers
By the end of the year, Netflix had 221mm World Subs. This was up from 204mm at the end of 2020, an increase of 9%. 17mm of net additions is a big number, but at that level it would only equate to 8% growth in 2022 (falling to 7% in 2023).
For the first quarter of 2022, management was skewed towards net additions of 2.5mm, versus expectations of 6mm. Looking at the graph above and it’s clear that while the adds are probably bouncing back a bit, let’s say that if Squid Games season 2 is getting people excited in H2 2022, sustaining a double-digit subscriber growth rate is probably near impossible. Especially since a lot of new competitive content continues to appear online (for example, the Game of Thrones prequel, House of Dragons, is set to premiere in 2022).
It was a little disconcerting that despite the strong slate of shows in the fourth quarter, subscriber growth disappointed.
The total addressable market has been described as 800-900 million for Netflix. This puts the penetration at 26%. Maybe it can reach 33%, which in five years puts the subs at around 280 mm.
By the way, HBO Max has 73mm subscribers. First mover advantage and highest quality content likely keep Netflix well ahead of Disney (NYSE: DIS) or HBO, but there seems to be a lot more potential for growth over time with, for example, HBO (which will be owned by Discovery by the middle of the year).
As we model Netflix over the next two years, we have assumed 10% subscriber growth this year and 12% revenue growth. Then, in 2023 and 2024, we saw 8% undergrowth and 10% revenue growth. By the way, these are still impressive numbers, but well below the peaks caused by the pandemic.
There is no doubt that demand has been pulled forward, and as Covid enters the endemic phase and economic restrictions ease, there will be less interest in watching TV at home than to travel and eat again.
Our assumptions bring revenue and EBITDA to $40.2 billion and $10.5 billion in 2024 respectively. We have increased our margins to 26% in 2024, up 600 basis points from current levels. The street is at $11.6 billion in EBITDA in 2024. That puts our estimates 9% lower than the sell side.
The biggest question we asked is what is the right multiple for a company that is growing its subscribers by 10% per year (in fact, the forecast is 8% for the first quarter of 2022, but should improve with a hefty half-list of shows), and revenues 12-13% annually. That seems a fair estimate for 2022, and possibly 2023 as well (although it could be lower).
Netflix is certainly a unique and extremely valuable franchise. Who isn’t a fan of their shows and movies? But even so, we’re struggling to pay more than 30 times earnings for Netflix stock, still a high multiple. There are unlikely to be any buyers of Netflix as a business, and growth can only slow from here. Maybe 25-30x is fair, as the market continues to drop multiples for growth stocks. But in two or three years, as the business matures, it probably won’t be worth 30 times as much. Growth will likely be lower.
On an EV/EBITDA basis, 18-24x seems like a reasonable range. Microsoft (NASDAQ: MSFT) trades at 20x, but has historically bounced around the ballpark 13-20x. Cloud spending and tech euphoria certainly took its multiple to multi-decade highs (not seen since it traded at 33x EBITDA in 2000). But its revenue growth looks similar, between 14% and 17% over the next two years.
Here are the compositions:
EPS growth estimates are somewhat dependent on Netflix continuing to grow its business. Seems like a tall order if the dollar continues to appreciate against foreign currencies, but doable in a stable environment.
Again, we assumed that a range of 18 to 24 times the EV/EBITDA multiple was fair.
Here are the proposed valuation scenarios, using our estimates (note Street’s estimates at the bottom, which will decline after this earnings release).
At $400 per share, it’s safe to say Netflix stock will rebound a bit. I’m probably a buyer in the lower $300 range, though, with a downside of say $250 and an upside of $545.
$545 is our bullish case and suggests respectable yield. But 2.5mm subscriber tips for the first quarter of 2022 weren’t impressive. Competition is everywhere, and that could also limit price increases. Many have argued that Netflix has such a powerful product that they could easily raise prices by 10% and no one would notice. This actually happened a few quarters ago. In Q2 2021, Netflix raised prices in the US and Canada, and subscriber numbers fell by 433,000. There’s not the pricing power that many assumed there was.
Last week, Netflix also announced a price increase in the United States. It has not yet taken effect but will likely weigh on subscriber growth in the second quarter as well.
While NFLX lamented the strength of the dollar in its press release and on its call, we’re not sure that will change in the short to medium term. In other words, their costs are almost entirely in dollars, but 60% of the revenues are generated outside the United States. Management estimated that it cost them $1 billion in lost revenue last year. A hawkish Fed will keep the dollar strong, it seems. We don’t expect that to come back anytime soon.
If Netflix fails to continue growing its business, the title will really struggle. If EBITDA margins grow to just 23% from 20% today by 2024, then EBITDA will only grow to $9.3 billion, well below Street’s estimate of 11.6 billions of dollars. Even at 24x EBITDA, NFLX is a $480 share in 2024/2025.
Granted, these are just multiples that I think are fair and what I’m willing to pay for Netflix. With cost pressures, tons of competition, and the strong dollar, we’re struggling to see that rate increase in the near term.
Discovery (DISCK) is trading at 9.3x proforma 2022 EBITDA. If their streaming business is only worth 15x, versus Netflix which is currently trading at 28x EBITDA (on 2022 numbers), then DISCK is worth $50 in 2025. We assumed a conservative 6x for their legacy cable EBITDA. It’s almost a duplicate on DISCK. We much prefer this risk-reward.