Wachiwit
While Netflix (NASDAQ:NFLX) has had a rough start to the year, I think that the bottom is in for Netflix as management focuses on efforts to rejuvenate growth in the business. While saving Netflix will be a mammoth task, I think that management has taken the right approach to invest for the long term and continue to put effort into finding opportunities to grow the business.
Investment thesis
The expectations surrounding Netflix have been too negative and gloomy and the result will be an outperformance by the company in the near term until the market’s sentiment around Netflix improves. Furthermore, we are starting to see Netflix become a free cash flow generation machine as it expects to generate $1 billion in 2022 and substantially more in the near term as it builds scale, improves operating margins, and re-accelerates revenue growth. Lastly, the company’s 2 main initiatives to increase revenue growth, the monetization of shared accounts and the introduction of an ad-supported tier, looks set to begin in 2023 and contribute significantly in the time to come. I have written an initial article on Netflix that can be found here.
Better-than-expected results
With expectations at rock bottom, I think that we saw the results of Netflix being able to surpass these low expectations and resulting in shareholder gains. While Netflix’s loss of 1 million subscribers may usually be seen as a negative sign, when this is put in the context of the management’s guidance of a drop of 2 million subscribers, it is actually positive. With the actual loss in subscribers slower than expectations of management, I think that we may be starting to see the effects of rather pessimistic actions as well as improving fundamentals for the company.
In 3Q22, management expects to add 1 million subscribers, which is down from the 4.4 million growth in subscribers in the year before. I would argue that there is conservatism in those numbers as management has baked in rather low expectations into the guidance. The lower expectations are a result of both increasing competition from rivals that are beefing up their own content, as well as worsening macroeconomic environment. Management also noted that the churn is improving in US as it is now approaching closer to the levels seen before the price hikes. In addition, management expects that global net additions will also be positive for the year.
I think that we are starting to see some re-acceleration of growth in subscribers as the fundamental landscape for Netflix improves. For 2022, I am expecting 3 million subscriber adds and for 2023, I am expecting an additional 9 million additional subscribers, with the new ad tier helping growth.
In 2Q22, ARPU grew by 7% year-on-year compared to the 6% growth in 1Q22. There was an acceleration of growth in US, with ARPU growth of 10% compared to 5% growth in 1Q22. The ARPU trends in Latin America were also healthy with growth of 15%. In addition, foreign exchange could continue to provide a headwind for Netflix and with a more challenging macro environment, Netflix could have a rather limited opportunity to raise prices.
Positive, sustainable free cash flows
We are finally starting to see the company be able to generate free cash flows as the company is expecting substantial $1 billion in free cash flows in 2022 and substantial growth in 2023. Based on the management call, I get out of it the fact that management is expecting the company to stay free cash flow positive and grow it significantly barring any significant foreign exchange movements.
I assume a cash content spend of $17 billion in 2022, which I think should remain rather similar for the next few years. Management said in the earnings call that they expect the free cash flows to really grow rather substantially over the next year as the company is past its cash-intensive stage. Furthermore, I think the fact that management also said that they pulled forward some cash spend in 2021 and 2022 leaves further upside for 2023. With continued efforts to scale the business and accelerate growth in revenue, as well as with increasing operating margins, these will all lead to Netflix being a very positive free cash flow business that can be sustained for some time.
New growth initiatives
Management has several new initiatives to grow the company that will be launched in 2023. The near-term focus for the company, in my view, will be to re-accelerate revenue growth and increase monetization. This comes in the form of a lower-priced ad-supported tier as well as restrictions on account sharing to monetize the low-hanging fruits of the large number of accounts that are currently sharing a Netflix account.
With the ad-supported tier, Netflix hopes to be able to provide an additional option to a group of consumers willing to pay less and watch advertisements. These lower-priced option helps Netflix capture a segment of the market it has not yet successfully served and given that the company has been in the business for some time, I think that it is the right time to add a new segment of customers when growth needs to be re-accelerated. Netflix recently announced Microsoft (MSFT) as its technology and sales partner. The company will be launching this new tier as soon as the first half of 2023. The combination of Microsoft and Netflix makes sense as Netflix has a large audience and content while Microsoft has an advertising business it wishes to expand. The model it intends to roll out the ad-supported tier will be similar to its usual model of rolling it out in some areas first, learn and recalibrate its strategy and approach before rolling out further. As such, I think that in the long run, we will see this new ad-supported tier grow into a rather significant part of Netflix and help to grow the subscriber numbers and grow earnings and free cash flows in the long run.
Another initiative Netflix is working on is paid sharing. This will help to monetize the more than 100 million households that are currently using Netflix but actually not paying for it. While the company is in the early stages of trying to monetize this significant number of households, the company will be first testing this out in Latin America. Similarly, this will first be tested, and the company will learn and improve the approach before rolling it out in more areas. This could go live in some areas as soon as 2023 and help Netflix monetize a rather valuable opportunity in Latin America.
While I think that in the near term, the impact of these actions may be small, they will grow to be more material over time and lift growth rates further. These growth initiatives will take time, but the efforts taken to refine the approaches will lead to a smoother execution and better experience for consumers.
Valuation
Netflix currently trades at 20x 2023 P/E. This is a discount to its 5-year P/E range of 70x to 383x.
Based on my estimates for 2023F EBITDA, I applied a 17x EV/EBITDA multiple. This multiple reflects the lower growth in the near term and flat margins, which I think is reasonable given the current macroeconomic environment.
Thus, my target price for Netflix is $270, implying an upside of 21% from current levels. As such, I maintain my buy rating for the company.
Risks
Pricing power
As highlighted above, with the current difficult macroeconomic environment, I think that there is the risk that Netflix might have a reduced pricing power. What this means is that Netflix may find it difficult to raise prices without a drawback in demand and loss of subscribers as a result of it. Price hikes for its subscription can bring incremental revenue growth from a higher average selling prices perspective and the loss of this pricing power may be detrimental to Netflix.
Competition
No doubt that this is one of the bigger risks as competition is coming for Netflix. From Amazon (AMZN) to Disney (DIS), there are countless companies attempting to benefit from the shift towards streaming that Netflix pioneered. With its first mover advantage, Netflix had something like a monopoly, but this will likely change as competition in the segment is increasing by the day as rivals spend large amount of money on content. This increased rivalry may bring lower revenue growth and lower margins as a result of competitive pressures.
Cash spend risk
If the company escalates cash spend to meet the rising competition, there is a risk that the company’s ability to grow and maintain its free cash flow position may be limited.
Subscriber risks
While expectations may be low for subscriber growth, if the company misses subscriber growth estimates, we could see further downside to the share price given the uncertainty in the subscriber situation.
Macroeconomic environment
With the current uncertainty around the macroeconomic environment, any deterioration in the economy may reduce demand for Netflix’s services and offerings. While the ad-supported tier may aid in this, the roll-out may take some time and any loss in subscribers as a result of the weakening economy will lead to lower revenues and earnings growth.
Conclusion
Management is doing what it can to help save Netflix. With the macroeconomic environment becoming tougher and competition intensifying, management’s new growth initiatives could help to re-accelerate revenue growth in the company. Furthermore, this is the first year Netflix will be generating positive and sustainable free cash flows that will make the business a sustainable one in the long term. With my target price of $270, this implies an upside potential of 21% from current levels.
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