Netflix Q1 Earnings: The Silver Lining (NASDAQ:NFLX)

Sentiment reached an all time low for the Netflix (NASDAQ:NFLX) stock after its 1Q22 report. While disappointing as I will point out below, I think that at the current share price levels, this is actually not the time to sell the stock. I would like to focus on what management intends to do moving forward and how that might impact Netflix’s stock price potential in the future.

Investment thesis

Netflix has had a stellar run as a streaming service company due to lack of serious competition in its early years. However, the competitive landscape is starting to change as there are multiple serious contenders beginning to take up more screen time and streaming market share from Netflix. While this new competitive environment may not bode well for Netflix, as shown in the recent disappointing 1Q22 results which showed slower growth and a loss in subscribers, there are some silver linings in the recent management call that we can look into. First, there has been a reset in the expectations for Netflix subscribers growth in the future, and furthermore, its net additions of 1.1 million users in the Asia-Pacific region. This makes it much easier for management to beat expectations on the subscriber growth front, and sets it up to further monetise elements of password sharing. Second, Netflix shared another lever it can pull for further revenue growth that management has opened up which includes an advertisements supported tier plans in the future.

In my opinion, there has been too much negative sentiment priced into Netflix’s current share price post the 1Q22 results. The company was once a pioneer in the paid streaming service segment and has the ability to produce many films and television series of its own and of decent quality. Although competition has now become tougher, I think Netflix has the first mover advantage, and top mindshare as a streaming service, and it will continue to benefit from the tailwinds of the shift from linear TV to streaming services.

Key negatives of the 1Q22 report

The biggest headline grabbing negative was the loss of subscribers for the first time. The loss of 200,000 subscribers in this quarter served a brutal blow to Netflix as it suggests that the growth story for Netflix has perhaps come to an end. Some of the reasons management has suggested was the impact of the Ukraine Russia war, churn as a result of competition from Disney’s (DIS) Disney+ and Hulu, Amazon’s (AMZN) Prime video and YouTube (GOOG) (GOOGL), and finally, due to macro factors like slower economic growth, inflation for example.

Another negative was that management expects margins to be relatively flat in 2023 as opposed to the initial expectations of 300 basis points improvement over a few years. This, in my view, reflects management’s cautious view on increasing competition and the need for increased spending to counter rising competition.

Lastly, management’s tone about competitors has changed to become more cautious and negative. Rising competition was mentioned in the call many times as management acknowledges they have some really good competitors and that Netflix needs to now take it a notch higher to be able to compete against them. Of course, this is a very different landscape for Netflix’s early days when it was the only streaming company around with a decent offering. This further worsened sentiment over margins needed to fuel future growth.

Continued content spend while maintain free cash flow positive

There is no running away from this. Netflix needed good content to attract and retain subscribers on its platform. The key to getting good content is to continue to spend on its original content and build on its expertise in productions.

When asked if the content spend of $18 billion expected for the year will be reduced or cut back with the loss in subscribers by the JPMorgan & Chase analyst, Netflix management pointed out that that is not the case. I think that this is the right position that management is taking, to invest in quality content for the long run potential of the business. Ultimately, when in a rising competition environment, I think that the need to spend on content and generate quality content is where the differentiation will lie in the long run and it is not the time for Netflix to cut back on spending just because of the loss in subscribers for one quarter.

Furthermore, when looking at the 1Q22 content slate, there were rather decent results from the content spend in the new content released for the quarter. For example, Bridgerton season 2 surpassing season 1 in terms of hours viewed.

Even with the increased content spend, management has continued to commit to being positive free cash flow for 2022 and beyond, which in my view is positive for the stock.

Monetising sharing

With a 100 million households sharing or using another household’s Netflix account as shared by Netflix’s management, the monetising of the ability to share does bring substantial opportunity in the near term.

The initial position Netflix took towards sharing of accounts was that it was good for Netflix as it helps to get people interested and started into watching Netflix. Netflix has launched 2 new paid sharing features to add additional households in 3 markets in Latin America. These incremental revenues flow directly to the bottom line and are a huge profit generation machine for Netflix if executed well.

I think that it is the right time to execute and act on monetising the sharing of platforms across households as Netflix has already been lenient for sharing for too long and it has achieved the purpose of making consumers start watching and stick to watching Netflix as a habit. Once these consumers have become sticky and used to watching Netflix, paying for the shared use of platforms should be a relatively low hanging fruit for Netflix. This huge 100 million households is thus an important opportunity for Netflix given that their penetration in several key markets like US and Canada has already reached a rather high level and to achieve any incremental results would require cracking down on sharing of accounts.

Ad-supported plans could provide a much needed boost

As CEO Reed Hastings pointed out, he changed his earlier stance on not having any advertisements on Netflix as he now sees a value proposition to a certain group of customers who are willing to have advertisements as part of a lower priced streaming subscription.

This is how I think about Netflix providing an ad-supported plan. With increasing competition from Disney (DIS), Apple (AAPL) and Amazon (AMZN), Netflix has to increase spend on its own productions and its original shows, films and series to add to its competitive advantage and ensure that it continues to have a reason for subscribers to remain subscribed. However, this increase content spend as a result of the increased need and mix of original Netflix productions means that Netflix needed to increase the price of Netflix subscriptions. This was the case earlier in the year when Netflix increased the price of subscriptions in the US and Canada, when the standard plan saw a price increase from $13.99 to $15.49. This represents an increase of only $1.50 but it is an increase of 11% in percentage terms. As such, for more price sensitive customers, this price increase was one of the reasons for the loss of 600,000 subscribers in the US and Canada.

Therefore, it makes sense for Netflix to offer a range of offerings, apart from its current standard plan, to provide a lower priced, ad-supported plan that will capture the demand for Netflix which is rather elastic. As such, I can see how this new ad-supported plan could add value to Netflix’s current offerings. It could provide Netflix with the much needed boost to its profits but as Reed Hastings pointed out, this could be more of a 2024 and beyond opportunity.

Valuation

I applied a 16x EV/EBITDA multiple to my 2023 estimates. For reference, Netflix used to trade in the range of 31x to 52x EV/EBITDA multiple. I think that the multiple reflects the relatively slower growth and flatter margin profile over the near to medium term.

This implies a target price of $255 and an implied upside of 14% from current levels. With this, I have a hold rating on Netflix. I think that the current sentiment on the company has turned very negative and now is not the time to sell. At the same time, I would need additional evidence of improving business conditions for Netflix to move into a buy rating given the risks involved.

In addition, Netflix trades at 17.3x 2023F EPS, which is such a discount to its usual P/E range of 70x to 383x in the past 5 years.

Risks

Subscriber growth

The risks to subscriber growth could skew towards the upside or downside compared to my estimates or market consensus. With the volatility we are seeing in subscriber growth, the number could surprise to the upside or downside, which has further implications for the investment case.

Impact of prices hikes

As mentioned earlier, price hikes were a partial contribution to the loss of 600,000 subscribers in the North America region. As such, price hikes need to be considered as a whole, in terms of its impact to the churn rate and subscriber growth.

Macroeconomic environment

As we saw in the recent results, management cited macro factors as one of the reasons for the weakness seen in the recent results. Volatility in the macro environment in terms of economic growth, inflation, as well as geopolitical risks like the Russia Ukraine war could impact and pose additional risks to the business.

Conclusion

As highlighted before, I think that the current stock price weakness of Netflix reflects so much of the negative sentiment that it makes no sense to initiate the company with a sell rating given the risk reward perspective at the current levels. As such, I have a hold rating for Netflix given the multiple silver linings, like monetisation of sharing, rolling out of ad-supported lower priced plans, continued content spend to boost differentiation. With a target price of $255, there is currently limited upside of 14% from current levels.