NFLX - Netflix: Long-Term Potential Vs. A Bad Rate Environment

2023-10-26 10:24:13 ET

Summary

• Netflix reports strong third-quarter earnings, solidifying its position as the leading streaming company.
• The company's first-mover advantage continues to benefit its long-term growth prospects.
• While there are challenges and risks, buying Netflix during price declines is a recommended strategy.
• I will discuss in brief many potential opportunities for the company that make it a buy, as well as significant risks to the story.

Netflix ( NFLX ) proves yet again that it is the streaming company to beat. Third-quarter earnings reported on October 18th came in at very attractive levels, and when you add in the first-mover advantage that the company continues to exploit, you come up with a long-term buy thesis that remains intact.

That doesn't mean there aren't challenges to the story, or risks...I'll go over them.

But I believe the company is a buy at opportunistic times - i.e., as you probably guessed, on price declines (in other words, be careful in terms of buying on strength).

I'll consider some of the numbers, but I also want to focus on some of the qualitative parts of the business model going forward, in particular some of the aforementioned challenges and how streaming may continue to evolve. This includes the deal with Skydance Animation and issues with residuals (and overall talent costs as well). I'll also mention valuation (again, while this stock is one investors can establish long-term positions in, dips will be your friend when establishing them).

I previously wrote about Netflix back in July, discussing its potential role in future media consolidation and changes in strategy. This article updates my thesis, with some elements essentially remaining the same: the stock is a long-term buy, as I've said, on pullbacks. Also, you'll find a similar bent in terms of my call for a theatrical strategy. But I have more thoughts on churn, talent compensation, and artificial intelligence (a speculative thought on the latter) to add here. Some of the valuation concerns are the same - however, the particular buy range mentioned then may be impacted by changes in the technical aspects and macro environment, with the latter heavily influenced by the action in the bond markets. I would still echo that between $360 and $405 would be a nice buy range, but I would also state that volatility may get worse, and we may see downside below the $360 level. In fact, the stock recently saw prices below that level prior to earnings, so going simply by the chart, a price in the $340 level could be revisited at any time if the technical setup favors a short-term double-bottom, for instance. We're just in that type of market right now; that's why I prefer buying and holding this top name.

Q3

The first item that will stick out to most shareholders is the subscriber-count growth. I did not see such a strong number coming.

The company added just under 8.8 million global members, bringing the grand total as of this date to better than 247 million users. Wall Street thought that roughly two million less added new members would have been in the cards. So did I, considering inflationary challenges and other macro issues, and challenges with streaming models in general. But the company has been doing well with password-sharing conversion and, presumably, the introduction of the advertising-supported tier. That was a good number.

Free cash flow for the year is now expected to be $6.5 billion against $1.6 billion for fiscal year 2022. You can back out about a billion bucks because of the strikes, but even at that, the company's cash flow is firming up over time. For Q3, the free cash flow was $1.9 billion versus $0.5 billion.

The GAAP earnings stat was $3.73 per share (against $3.10 in Q3 of 2022), which was over twenty cents ahead of expectations. Top-line sales of $8.5 billion met expectations. Share count has remained steady at 450 million since the comparable quarter.

That completes a brief review of quarterly data. I'll move on to thoughts on the longer-term strategy.

Netflix - Future Potential

There are a few bullet points I will briefly discuss:

• Theatrical strategy (I will consider Apple's ( AAPL ) recent experiment with the new Scorsese picture as a comparison)
• The strikes, with consideration of residuals and compensation
• Future impact of churn
• Gaming possibilities
• How advertising can be leveraged more aggressively
• The deal with Skydance Animation
• Speculative thoughts on artificial intelligence

Theatrical strategy: I continue to pound the table on this bullet point because I believe it to be something in which Netflix should invest now rather than later. Emphatically so.

Yes, the company doesn't believe it should do so, but then again, the company also famously stated its aversion to advertising tiers - remember that?

However, my hope is the company understands that it should be ahead of the curve rather than be compliant when the curve arrives. I actually believe it's only a matter of time in the next few years before Netflix does announce a more rigorous strategy.

There are a few reasons for this, and they intersect with a couple other bullet points, so I'll get to them momentarily - for now, let me bring up Apple and its own multiplex-money model.

This weekend, Apple released, along with Paramount Global ( PARA ), a new Martin Scorsese movie, Killers of the Flower Moon . It's not tentpole IP - it's an Oscar-type film whose release will definitely satisfy the famous director's preference for a theatrical platform as opposed to streaming-exclusive.

It will bring in some cash, though. It ended up grossing $23 million in its debut, good for second place against the Taylor Swift project.

Apple isn't necessarily doing this to deliberately reap a profit from the silver screen - as the tech giant's own theatrical strategy evolves, making commercial tentpoles will come to dominate the release slate (according to my strategy forecast, anyway). For now, this is an offsetting influx of revenue against the $200 million cost for the feature, one that is windowed in anticipation of an Apple streaming release. The economics will have to change to get closer to probable profitability.

As time goes on, releases such as this will pressure Netflix to step up its game and go beyond half-in/half-out multiplex tests such as the distribution strategy for the Knives Out project last year . Eventually, theatrical will be an actual, significant revenue source, one that can differentiate one streamer from another.

But there is a complication to content production, whether it be theatrical releases or exclusive streaming debuts - Netflix has to pay out residuals to talent in addition to backend buyouts. If the strikes from the writers and actors guilds have taught us anything, it's that costs are going to rise on that front in the coming years.

Compensation costs, whether they be backend buyouts or residuals, represent the big issue for streamers...and, yes, that includes Netflix. While everyone says - and rightly so - that, sure, any streamer not named Netflix has a questionable future of growth ahead of it, the company should not fool itself into thinking that content makers will simply sit back and watch as free cash flow widens and the stock rises and not raise any objections; on the contrary, the demands for higher payouts will get louder, you can bet on it.

What we may end up seeing is less tentpole product on the service and more of the longer-tail, lower-quality tiers of programming - in other words, the stuff you consume after Stranger Things and other zeitgeist-material that you immediately forget post-consumption. That presumably is how the company plans to pull the levers it's always talking about in terms of expanding cash flow versus cash usage.

But, going back to theatrical strategies, the latter can help out, as well. Netflix could create tentpole product for theaters and offer higher cuts to talent as a way of lessening the cash it has to pay out from corporate coffers. Here's a thought experiment: Netflix produces a film with Ryan Reynolds, one that could lead to a franchise with a big toy-merchandise component attached, and gives him an outsize percentage of the cash-breakeven gross in exchange for a smaller backend buyout for when it hits the service; in addition, he takes a healthy portion of the merchandise sales. If Netflix fostered outside revenue sources such as theatrical, not only might it be a solid business line of its own, but also there is the potential to strike unique deal structures with talent that doesn't interfere with the prime mission: maximize free cash flow while reducing overreliance on debt funding.

Churn will definitely be part of Netflix's future, and while the company is currently doing well growing the subscriber-count metric, one has to wonder how the churn metric will be affected over time once the password-sharing well dries out.

We all know Netflix will mature as a company at some point into a capital-return/cash-flow concern - that will probably happen at a time when the business really hits a churn problem. Again, this is where theatrical could help by keeping people on the service in anticipation of getting the first digital window of any multiplex product. Comcast ( CMCSA ) likes to promote Peacock that way, for instance, and the aforementioned Apple certainly will use the Moon project in similar fashion.

Churn is going to be tough to address once subscribers begin to feel contented-out, if you will. Another way the company believes it will add value to keep subscribers sticking around is via the introduction of video games.

Gaming was discussed in the conference call. Here's what co-CEO Greg Peters had to say on the topic:

"Well, let's start with the big prize. I think that's the better way to look at it, which is games is a huge entertainment opportunity. So we're talking about $140 billion worth of consumer spend on games outside of China and outside of Russia. And from a strategic perspective, we believe that we can build games into a strong content category, leveraging our current core film and series by connecting members, especially members that are fans of specific IPs with games that they will love. "

Pretty boilerplate, non-specific stuff, but I do believe the company is serious about the commitment. My concern is this: while the company will want to integrate gaming into the service, it should also want to sell physical games and turn that into a consumer product. Don't leave that aspect out.

And I'll also point out that the company should look toward the classic-game market to figure out how to most cheaply produce video games that will attract buyers/subscribers. I've often wondered why companies such as Disney ( DIS ) went out of their way to spend billions developing something such as Infinity when they simply could have looked to the past and put their IP on previous gaming engines that emulated the feel of what worked back then. An example would be the Super Star Wars series, or Contra , or old point/click games such as ones made by Lucasfilm. That actually might be what Netflix wants to do to some extent, but I assume the company will want exposure to the more expensive side of the industry - the Red Dead Redemption , the Resident Evil , side. Also - and this is understandable - the company intends on focusing on mobile titles. Granted, that would be smart, and perhaps because I don't play phone games (yes, I am still stuck on physical Atari 8-bit stuff) I may have some bias here, but I do think Netflix should court the more classic esthetic to keep costs down and marketability up, as I believe the golden-age look appeals to many younger demos. If you look at YouTube, for instance, you see a lot of gameplay videos that could easily be leveraged toward selling digital copies of the games being played via a link. Netflix could do something similar - strike a partnership with an Atari, as an example, and put content on that features Atari games (maybe an eSports-type game show) while linking to a digital copy for sale. More likely, the model should center on Netflix-created titles. And when Netflix links to titles eventually streaming on its own service as part of a subscription, it can monetize that with an advertisement.

Speaking of advertising, I'll briefly segue to the need for Netflix to consider exactly what a streaming ad will look like in the future. Remember, this is the company that engaged the first disruption for its nascent industry, so it would befit the aforementioned Peters and co-CEO Ted Sarandos to innovate in terms of ad placement. For one thing, the company should investigate aggressively getting into product placement; whatever it is doing now in that regard, it should increase the activity. The company might also look to the idea of taking content from others for a fee to promote perhaps a new franchise series, a new comedian on the rise, a podcast, or a toy line. Unique sponsorships might be arranged that don't involve creating an ad load. Such suggestions might work on both ad-free and ad-supported tiers, with the greatest benefit coming to the ad-free version (in other words, figure out a way to advertise without the need for commercial breaks).

There also should be mention of the deal with Skydance Animation, a production outfit previously in league with Apple. Sarandos said that Skydance essentially aids the company in scaling up its animation ambitions. The problem with this deal - yes, you can guess my complaint - is that according to trade articles it doesn't seem likely that there will be a theatrical component; it appears instead (for now) that the computer-cartoons will come out on the service exclusively. Wrong move. Skydance Animation, led on the creative front by former Pixar executive John Lasseter, could easily, assuming a few hit theatrical tentpoles, solve some of Netflix's problems as it concerns growth, churn, and consumer products (and yes, on the latter, add gaming to that, as video games based on hit animated projects can be popular). Again, I don't expect this to be a static situation, just as the company's previous aversion to advertising took on a more dynamic reality - I'd have to imagine Lasseter will push for platforming at the multiplex since he was used to that over at Disney. There's no reason Netflix wouldn't want to make that investment.

The last thing I'd like to mention is artificial intelligence. Yes, in the most speculative paragraph of this piece, I openly wonder if Netflix may utilize AI, but not necessarily in the way one might think (i.e., not just as a way of optimizing recommendation engines).

In an attempt to imagine how the company will disrupt its next disruption and differentiate itself from competitors, and given the proliferation of apparent consensus that AI will truly transform tech (hey, the consensus could very well be incorrect, and I am careful not to get too excited about this technology considering how early everyone was on the metaverse, but let's go with this theme for a moment), I contemplate a time when Netflix will create an intelligence-engine that allows subscribers to upload their own scripts to generate custom content, utilizing libraries of thespians that license their likenesses to act out users' ideas. Too early of a thought? Something destined to remain a thought experiment? Well, union guilds seem frightened enough of AI to take the subject very seriously, and while I am no expert in AI programming, I am going to assume a content-making tool such as the one I described - and let's be honest, many others have probably thought of this as well, I can't be the only one - might exist in some form in the coming years. It would surprise me if Netflix doesn't have capital in R&D allocated toward such a business model (of some sort, if specifically not the sort I described), because one day, maybe the only way to engage a certain segment of the audience will be to give specific users what they specifically want (and maybe share the best of the script-prompts with the entire global subscriber base, thus making Netflix a new kind of social-media platform). At any rate, take this notion as another reason to invest long-term in Netflix and other Hollywood tech giants (such as Apple and Amazon ( AMZN )): when shareholders least expect it, the next unimaginable disruption will come along and offer another boost of growth to your stock. Food for thought, as they say.

Thoughts On Stock Valuation

At the time of writing, Netflix shares were sporting a $400-handle; to put this in perspective, the 52-week range is defined between roughly $250 and $485.

The SA valuation tool is very cautious on Netflix, giving the stock a D- grade (also at time of writing).

The various statistics stress the relative effect on valuation to the sector median. Not so good numbers.

But...consider the historical valuation averages relative on an internal basis to the stock. As an example, the forward PEG ratio on an adjusted basis is currently nearly 20% cheaper than the average. EV/EBITDA (forward) is 30% on sale.

My take is that Netflix represents a good long-term risk, even for someone who wants to average in starting now; keep in mind, for instance, that SA's growth rating is currently high. I would not make big purchases at any one time, however, because the stock is closer to the 52-week high, and it recently did show strength after earnings. (And I'll refer back to the beginning for my thoughts on price action and buy range.)

We have to go a step further, though. Realistically, beyond all of this, we have to consider the market environment we're in.

Obviously, people are singing the song from that musical that goes something like we've got trouble, with a capital T...and in this case, that stands for treasuries. Anyone investing now has to be very aware of the effect interest rates will have on any purchase; a growth stock like Netflix has to be valued against that backdrop, both on a technical and fundamental-discounted-cash-flow basis. Rates make Netflix potentially expensive, there's just no way around it.

As investors, though, especially ones with long-term horizons looking to position themselves with best-of-breed leaders, Netflix has to be considered off its recent earnings and potential opportunity story.

What risks, though, do investors have to keep in mind? The usual suspect of churn based on subscribers tiring of content and deciding to switch to another streaming platform could be at the top of the list. Why is this? Mostly because it is so easy to switch; there's virtually no friction to the process, and companies don't fight to keep you like cable concerns of yore. Related to that, there is the risk that the company's pricing power, derived from its first-mover advantage and valuable brand equity, dissipates more quickly than imagined. Content expenses could shoot up unexpectedly because of talent demands or managerial missteps, impacting cash flow. Changes in leadership could also pose problems (e.g., if Ted Sarandos suddenly decides he'd like to run another media company).

This is my kind of stock as an individual investor - it's a good idea to add to over time, hold, watch, and buy when big-percentage drops materialize during volatility. Netflix just doesn't seem like it's done growing yet.

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