Netflix Stock: The Great Misunderstanding, Starting At Sell (NASDAQ:NFLX)

Premise – Wall Street Partially Misunderstands Netflix’s Model; Re-evaluation Could Lead to Large Downside or Large Upside – Neutral For Now

Our basic belief is that a large portion of the sell-side community and buy-side fund managers that are bullish or long Netflix (NASDAQ:NFLX) are incorrectly viewing the company through a tech lens. The reality is, in our belief, while Netflix may have some limited form a technology moat, it is, at its most fundamental level, a media company. We’ve identified some bullish and bearish potential catalysts before YE’2023 that could lead to outsized upside/downside:

Bearish Catalysts:

1. Continued Churn in Paying Subs in UCAN+EMEA geographies
2. Possibility Of Weaker Content Slate Slowing New Adds Growth in ’23
3. Potential For Attrition Among Paying Subs If They Move Down-Market To Ad Supported-Tier Making It a Net-Negative as it Ramps Next Yr
4. Competition From Other Streaming Platforms (Disney+, Paramount+, HBO Max, etc.) As Well as Events Like Sports, Elections, Etc. Ramping into YE Eating At Sub Share
5. Slower Evergreen-ing of Originals than Anticipated
6. Volatile Cash Flow Surrounding Cyclicality/Seasonality In Production Spend + Marketing
7. Slower 2H Sub Growth Than Consensus Expects
8. Weakening Consumer Discretionary Spend Means Greater Churn into ’23 if Macro Continues to Weaken

Bullish Catalysts:

1. Netflix/Microsoft (NASDAQ:MSFT) partnership could spark talk about M&A
2. Scaling interactive content (i.e. gaming) could help to entrench engagement, reduce churn, and diversify revenue build
3. AVOD tier is sub-accretive, and Long-Term ARM per AVOD sub @ scale is > Standard Plan SVOD ARM.
4. Content Teams Perpetually Underestimated, Originals Team Can Keep Firing Off Hits (Squid Game, Stranger Things, etc.) Juicing LT Retention and New Sub Growth in New Geographies
5. Netflix stabilizes the growth of or even reduces cash content costs driving LT FCF leverage
6. Layoffs Could Help Ease Margin Pressure Through Tougher Macro Environment Delivering possible EPS upside surprise
7. Effective Password Sharing Crackdown Could Be Revenue and Margin Accretive In The Same Way A Direct Price Hike Would
8. Potential Continued Pricing Power Leverage (Ex. Economic Cyclicality)

Our Q2 Takeaways – Numbers Were Lukewarm At Best, Still Hazy on PW-Sharing Opportunity & Advertising Rollout

Our key takeaways on the quarter were as follows:

• the numbers themselves were lukewarm at best
  • FX key driver of revenue miss, one-time accounting adjustment drove EPS beat
  • 2Q subs better than expected, but UCAN churning hard despite Stranger Things 4 release
  • Q/Q sub growth guided a little soft, but still positive
  • net-net subs came in better than expected, and potential draconian buyside fears of millions of net cancellations were quelled
• AVOD product is still young, management still working through the kinks
  • going to be a little more complicated than an ad-supported tier
• early brand demand to advertise on Netflix high per management
• management optimistic on content slate into 2H, particularly w/marketing strategy and release of ‘The Gray Man’ movie
  • management pointing to hit marketing campaign for ST4 as evidence
• PW sharing crackdown viewed as a real opportunity
  • management sees as evidence that content is appreciated
• staggered release helped with demand for ST4
• Cash content spend could flatten out from here, or at least grow slower than revenues
  • cash content spend stabilizing at $17-$18B would enable FCF leverage if top-line grows swiftly
• expect ‘substantial’ FCF growth in ’23 vs. ’22 (expected at $1b +/- a couple hundred $mm for ’22)
• 60% of content assets on balance sheet are Netflix produced.

The report showcased a slower Netflix, with one-off headwinds and one-off tailwinds (FX accounting adjustment for EPS) throwing the numbers a little bit. Our big takeaway from the release and the call is that Netflix continues to work through churn in core, high-paying geographies and that we don’t have much to grasp onto yet on advertising/PW sharing.

Tactical Thesis – Netflix Is Going Into A Challenging Macro Operating Environment With Idiosyncratic Risk Over the Next 6-12 Months

Our tactical thesis is this: the operating environment, from a macroeconomic level, right now, is relatively strong. While some see the company being relatively recession-proof, we see a constrained macro environment hurting discretionary spend, and thus Netflix. Additionally, we see idiosyncratic risk with regards to competition, continued high content spend, and lack of a true evergreen originals library. Additionally, as more entrants move into streaming, we think competition for content licenses is an underrated issue that the Street might not be paying enough attention to.

With regards to the operating environment, we see the current operating environment (as of July ’22) as being relatively strong for discretionary spend. We are worried that current churn dynamics are less a factor of macro debilitation and more a factor of idiosyncratic problems (i.e. content slate, brand, and competition). We are worried about brand issues domestically, with frustrations on both sides of the political/cultural aisle (Dave Chappelle on the left, ‘woke content’ on the right as possible examples) driving attrition in the subscriber base. We think that Netflix has certainly become more of a cultural lightning-rod than it had been in years prior. To put it bluntly, that isn’t good when your business model is charging customers $100+/year for your service.

We see the likelihood of economic contraction increasing greatly over the next 6-12 months as interest rate shocks, geopolitics, and energy crises (among many other things) take their toll on the world economy. We think for the most part, cancellations to date have been driven by company specific problems, and not current macroeconomic hurdles like inflation. We underscore this point.

In addition to a devolving macro environment that will lead to increasing churn and weighing on global sub growth rates and streaming adoption, we remain concerned about idiosyncratic risks. We think competing products like Paramount+, HBO Max, Disney+ and others have much better evergreen content libraries (think Star Wars, Marvel, etc.), and we continue to be concerned about user attrition on Netflix as these platforms expand offerings.

Finally, if top-line trends deteriorate, we are concerned about the flow-through effect to free cash flow. Netflix operates with a large debt load, and a relatively small amount of cash in relation. We wonder if the balance sheet is prepared for mounting idiosyncratic and macroeconomic challenges.

As a result of these challenges, looking out to next year, we’re cautious relative to the Street.

From here out, we see two paths, paths that we further model in our valuation section on ‘bear’ and ‘bull’ cases.

Path 1 – As Challenges Mount, And Management Fails To Navigate Properly, The ‘Tech’ Narrative Will Fall Apart To The Downside

Our first path is the more draconian path. In this scenario, we see economic conditions continuing to deteriorate, especially domestically as interest rate hikes constrict economic activity by making credit more difficult to access. In this scenario, we see a tide of rising layoffs, decelerating inflation, and both decelerating nominal and declining real GDP growth.

We see pressure on consumer discretionary spend as well as travel. As households look to become more austere in spending habits, we would anticipate an uptick in churn, or at least greater variability from households when choosing between different streaming services.

This type of macroeconomic degradation is almost impossible for a management team to counter, especially for a company as tied to consumer spending as Netflix.

We see the combination of idiosyncratic and macro headwinds mounting to put pressure on cash flow, resulting in a change of tune on the way investors view Netflix.

We think that if churn increases, revenue growth decelerates, and cash flow worsens, investor perception will too change. At that point we think investors will no longer recognize Netflix as a tech company to be bundled in with FAANG, but a purely media company.

In this scenario, we see ongoing initiatives like advertising and the account sharing crackdown failing or being mediocre. For instance, an advertising tier (if we conceptualize the advertising push like that even though it will be more intricate than that) doesn’t lead to an incrementally expanding subscriber base, but leads to attrition from the core, higher monetizing SVOD group, a net negative result. And from a base case view, we don’t think that’s too unlikely. We think advertisers chase eyeballs, and until an AVOD tier builds up eyeballs (incrementally and through cannibalization of higher tiers) brand advertisers will likely be reluctant to budget big. So you might need some time for this supply-demand balance to swing into equilibrium before you can label the initiative a success/failure. Additionally, in this scenario we see a lower percentage of account-sharers in the mix being likely to pay for password sharing. Netflix estimates 100 million households globally are using the platform through shared passwords. In the bear case, we see very few of these periphery, non-paying accounts being willing to pay a small monthly fee to share the account, and instead will continue to resort to using the platform in the prior way.

Path 2 – Macro Starts to Alleviate by 2H’23 And Netflix Revenue CAGRs at HSD/LDD While FCF Multiplies

The second path for Netflix is a fundamentally optimistic one. It’s a path that could actually lead to the meaningful positive rerating of the stock, even if it is fundamentally perceived as a media company, over the course of the next twelve to eighteen months.

For those that don’t know our baseline macro view, we see the FFR (Fed funds target rate) peaking some time in 1H’23, when we believe max pain in the economy (on unemployment, NFPs growth, and GDP growth) will be felt. We see a set up for the Fed to unwind hawkish policy (rate cuts + slower balance sheet reduction) into the back-half as inflation unravels and the economy and markets look to a more accommodative Fed to stimulate activity.

We think that an improved 2H’23 directly correlates with an improved outlook for consumer discretionary spending trends, and thus improves the macro backdrop for Netflix. So this is somewhat of a base-case assumption. We could be wrong, in that a Fed pivot in 2H actually doesn’t spur the type of economic activity necessary to bring consumer spending up, but alas we digress. We think this more optimistic path entails fast, scaled, and accretive adoption of an ad-supported tier next year from new subs, met with high demand from brand advertisers. That lumpy period between supply-and-demand that we mentioned earlier is shorter in this scenario.

Under this optimistic lens, we also see a higher penetration rate of those willing to pay for account-sharing within that group of 100m global households, which we think is substantially, and almost immediately accretive to both revenues and cash flow.

In this scenario, Netflix’s content team cranks out new hits and follow-ups (think Squid Game 2) to keep adding subs globally, reduce high-value UCAN/EMEA churn, and enable future pricing leverage. We also see an improved content slate as beneficial to branding, something that we think has slightly eroded of late (as mentioned before).

We think all of these factors, when put together, along with a more disciplined and steady-state approach to content spend, could enable a high-single digit (~7-9%) to low double digit (~10-13%) revenue CAGR from 2023-26 as well as a multiplication in free cash flow. On the FCF front, we think cost discipline (primarily via trimming excess headcount and stabilizing content spend growth) would enable meaningful FCF leverage, multiplying management’s ~$1b ’22 FCF expectations within a few years.

The Probability Game – Which Path Is More Likely?

Our inclination is to say the odds of either scenario playing out are about 50-50. We see a very rocky 2H’22 for Netflix, as we see inflation subsiding along with real economic activity, driving down discretionary spend. Additionally, we continue to see a relatively elevated amount of company-specific risk (relatively dry content slate + continued competitive headwinds + weak CTV buying market) effecting KPIs for at least the next two quarters.

On the long-term note, we are cautiously optimistic on management’s ability to (a.) slightly re-accelerate revenue growth (via AVOD, PW crackdown, pricing power, and improving sub trends/churn) and (b.) deliver FCF leverage in time (stabilize content spend, reducing headcount). Netflix has been around for decades, with this management team having experience navigating macro-economic turbulence and transitions. If we were long, we would take some comfort in that. The transition from DVD mail to streaming is a lot harder than from SVOD to SVOD+AVOD+paid sharing. That’s our two cents at least.

We think the probability of outcomes is pretty mixed at 50-50 right now between Path 1 & 2, but we also think that 2H’22 subscriber trends will be weaker than expected, leading to reduced expectations into 2023. If there were to be a time to buy the stock at scale, it would likely be in early 2023 as economic conditions devolve and the business takes a hit, that is, if you believe a transition into Path 2 is reasonable.

Medium-Term Outlook Is Rocky – We See Downside Risk in 2H

While our blended long-term outlook on Netflix is relatively neutral, we would assert our concern/pessimism about the company’s ability to meet expectations into the back-half of this year.

Netflix stock has historically traded on its ability to hit subscriber growth expectations and how they guide for the forward quarter. In 2Q subs beat while sequential sub growth guide for 3Q missed. All told, the net-net was that Netflix beat subscriber expectations.

One of the most concerning highlights for us in the quarter, was that the raw subscriber number was juiced by lower ARM users in the APAC geography, while churn in higher ARM EMEA and UCAN actually accelerated q/q. This is most interesting in EMEA, considering the fact that the Russia-Ukraine headwind likely led to elevated churn in 1Q relative to normal. And yet, in spite of that, Netflix saw net subscriber losses accelerate into 2Q. Not a good sign.

While we think that 3Q subscriber numbers will likely be buoyed through July and maybe August primarily by way of Stranger Things 4’s staggered release schedule, we are concerned that a drier content slate could see trends reverse as the quarter unfolds. We are also particularly worried about expectations surrounding 4Q guidance. We have seen multiple sell-side estimates projecting 5-6m sub adds in 4Q with ~1-2m expected for 3Q. While the seasonal trend may be on the bulls side, we still don’t think the macro environment, competitive dynamics, or content slate are. Thus, we would caution long-term investors on buying the stock here with meaningful de-risking to expectations still to come.

While we see some type of seasonal acceleration in sub adds (likely driven by non-EMEA/UCAN geos) we don’t think the environment for Netflix to grow subs at a 5-6m q/q pace exists right now, and are therefore cautious. We see somewhere in the neighborhood of ~1.1m sub adds for 3Q, and closer to 2-3m sub adds for 4Q, putting us well below Street for 2H growth.

And again, these aren’t unreasonable targets. Considering the devolving macro picture, a competitive climate that is only heating up, and Netflix’s relatively dry content slate for 2H, we think these numbers are within reason.

Valuation

We formulate our valuation and price targets base on what we think the market will give the stock on FY’24 forward numbers by YE’23. We outline our projections with base, bull, and bear cases to reflect possible scenarios. These estimates our underpinned by our internal model, not on display here.

F’24 Base Estimates	KPI
FCF (in $b)	$3.9
Tgt. FCF Mult.	22x
Implied Valuation	~$85.8B
Shares Out. (in m)	444.71
YE’23 Base Case PT	$192.93
+Upside/-Downside	-11.36%
Rating	Sell

While we aren’t going to publish our internal model, we will walk through the estimates and our rating a bit to clarify our take. Our FCF projection assumes that Netflix scales revenues from ~$31-$32B in ’22 to ~$39B in 2024. Additionally, the FCF output assumes decelerating content expense growth and stronger margins (via pricing increases mostly). Additionally, the base assumes that PW sharing initiatives and AVOD are net accretive on the revenue side, driving a reaccelerating in revenues. Our base assumes macroeconomic recovery in 2H’23 and into 2024, fueling a strong backdrop for Netflix’s business.

On the multiple, we use 22x to reflect a view that Netflix can drive upside to revenue long-term (via pricing power, strengthening in-house content slate, strengthening brand, AVOD/PW sharing, and more) at an HSD-LDD CAGR. We also assume Netflix targets long-term FCF margins in the range of 10-15%, enabling continued rapid growth in FCF. To be clear, we do not believe 22x is a proper steady-state multiple for Netflix’s cash flows. But, considering the fact that our base case is Netflix is early in its FCF growth cycle, the multiple seemed to sport an appropriate premium relative to normal stock market multiples (15-17x).

Our rating is a Sell for a simple reason. Normally, considering the generally mixed bull-bear dynamics we would put Netflix closer to a Hold. However, we see catalysts to downside (2H sub expectations in particular), as well as greater net risk than reward (in our bear v. bull assumptions). As a result, we’re starting coverage at Sell.

F’24 Bear Estimates	KPI
FCF (in $b)	$3.1
Tgt. FCF Mult.	17x
Implied Valuation	~$52.7B
Shares Out. (in m)	444.71
YE’23 Bear Case PT	$118.50
+Upside/-Downside	-45.37%

Bear case assumes slower top-line growth (AVOD cannibalization, macro headwinds, slow APAC/LatAm/EMEA sub growth, higher UCAN churn, low PW sharing monetization) as well as slower FCF margin growth (stickier content spend and recurring cost growth). The multiple reflects a slower growth, lower terminal FCF margin business.

F’24 Bull Estimates	KPI
FCF (in $b)	$4.8
Tgt. FCF Mult.	26x
Implied Valuation	~$124.8B
Shares Out. (in m)	444.71
YE’23 Bull Case PT	$280.63
+Upside/-Downside	+29.4%

Bull case assumes revenue growth scales at a low-double-digit pace from strong macro, AVOD/PW sharing being accretive to margins and revenue, and ever-greening of IPs enabling pricing power and strengthened brand. Our FCF margin assumes Netflix stabilizes content expenses and SG&A via layoffs, cutting the fat off the business. Multiple reflects a narrative that Netflix is a strong media business with levers to pull on revenue (think pricing power, AVOD, etc.) and FCF expansion.

Conclusion – Starting Netflix at Sell, Waiting on Downside Catalysts to Play Out Prior to Any Upgrade

In conclusion, in spite of what we see as a relatively 50-50 risk/reward picture long-term on the fundamentals, we see the stock’s risk/reward as being heavily skewed to the downside.

Investors who are paying a technology company’s multiple may need fundamental downside surprises to shake consensus into a more grounded perception of the company: It’s a media company. Our valuation framework across base/bull/bear accurately reflects different version of what a Netflix ‘media company’ narrative would look like.

The risk/reward is skewed down for now. We would wait on 3Q earnings and 4Q guide likely before upgrading the stock. Until then, we’re starting coverage at Sell.