Netflix first announced their ad tier and paid password sharing plans in April 2022, just about 12 months ago. And since then, they have continued to promise that these two major service changes would increase revenues, improve margins, generate more cash flows and reward shareholders. Now the stock has certainly been rewarded, almost doubling since mid-May 2022. However, there has been slow progress on almost everything else.
Let’s take a closer look at NFLX’s Q1 earnings report to understand why…
Q1 earnings report card
Revenue: Q1 revenue was $8,162M 3.7%yoy. They missed Q1 consensus estimates by $178M due to delays in new revenue generation from the ad tier and password sharing crackdown. Revenue growth was strongest in the US, Canada, Latin America and weak everywhere else.
Forward estimates: Q2 revenue estimate was revised lower by about $240M to $8,242M 3.4%yoy. Ad tier and password sharing contributions to growth have been further delayed to Q3 and Q4….could be even later depending on how the planned rollout goes. That said, NFLX is pivoting to higher yoy growth in 2023 and is targeting double digit growth by the end of the year.
Margins: All margins are still trending lower…gross margin (41%), EBITDA margin (64%), operating margin (21%) and net margin (16%). They continue to blame currency effects for these lower margins - Netflix tends to “whine” a lot about foreign exchange impacts rather than hedging currency effects like most other international companies. Other expense categories are stabilizing towards a new norm. They are narrowing and refocusing their content spend plans - I like this, however they still plan to spend $16-18B on content in each of this year and next.
Cashflows: Cash flows continue to be strong and improving - this is their best business fundamental metric by far. Operating cash flow and net cash flow, each, came in more than $2B in Q1 2023 itself…more than all four past quarters combined. They plan to generate $3.5B free cash flow in 2023, raising their previous target by $500M. However, let’s also understand that these cash flows are bolstered by the amortization of their content assets over time…a bit of cash flow accounting that is specific to this industry.
Cash and debt: Cash on the balance sheet rose by about $1.8B to $7.8B, however debt also rose to $14.4B. Their debt to cash ratio of 2+ is still one of the largest yokes among the companies that I track. With their continued massive annual spend on content, this is not likely to change anytime soon.
Shareholder value: Shareholder dilution keeps trending down due to lower stock based compensation and share buybacks ($400M in Q1 alone). Institutional ownership has returned and risen for the past 3 quarters.
Marketshare: Customer adds have been stagnating in the 1% quarterly growth range for at least the past 7 quarters. This is not expected to change in Q2 either. The much anticipated ad tier and password sharing member growth has been delayed…now promised towards the end of the year.
Product: The ad tier service is now available in 12 countries, including the US. Paid password sharing is now live in 4 countries and is due to launch more broadly, including in the US, in Q2 2023. Both of these services are still in experimental mode with respect to pricing, user experience, content viewership, ad revenue etc. NFLX is still learning about what is working and what is not, how to maximize their revenue per subscriber without cannibalizing the other pricing tiers. It is too early to tell what the true revenue uptick will be once both these services are completely rolled out and the results can vary by country. NFLX reduced prices in 116 countries in Q1 2023 to stay competitive, although they told us that these regions represent less than 5% of 2022 revenue.
Valuations: Morningstar retained their fair market value of $315. Taking into consideration enterprise value, gross profits and forward growth, the stock is one of the most overvalued stocks that I follow. This richness is also reflected in a forward PE of 30.
Beachman score: The stock improved its Beachman score to 14 points (out of a possible 30 points) due to higher institutional ownership and the new share buy back program.
NFLX disappointed investors with this Q1 earnings report. Expectations were high. Q1 was supposed to be the start of a great new era, similar to when they shifted from mail-in DVDs to online streaming.
Alas, investors will have to wait a bit longer…maybe Q3 or it could be delayed to Q4 or later. Even after the full rollout, it is not clear if the new services will eat away revenue from the existing higher priced subscription tiers. And the fact that they had to reduce prices in 116 countries to stay competitive does not bode well. Remember, the global economy is heading into a recessionary slowdown and the consumer could start sharpening their pencil when it comes to discretionary spending like streaming services.
And why do they need two CEOs to run the company? It’s like the show “Succession” - Reed Hastings could not make up his mind on who would be the better leader in his stead?
To be fair, NFLX is doing some things right especially expenses management and shareholder dilution. Continued progress on these two fronts is crucial to maintain Wall Street’s attention.
I am not interested in adding NFLX to my portfolio at this time. The stock has been bid up in anticipation of future revenues from their ad tier and paid-sharing subscriber growth. The promise of both these future revenue streams is yet to be understood, proven and accurately estimated. As an investor, I would not buy it here. As a trader, I would short the stock now.
One analyst on SA said it best a few months ago, “Netflix is a media company in a mature growth stage, and unfortunately, it is being priced like a technology company in hypergrowth.”