Investment Thesis
The last time I wrote about Netflix, I mentioned how the actors’ and writers’ strikes were unlikely to have an adverse impact on the company relative to its peers. In this article, I discuss the company’s Q3 performance and argue why moves such as price increases and increased push towards animated movies, demonstrate the company’s ability to grow even in a challenging environment.
A Snapshot of Netflix Q3 Earnings
Netflix had a decent quarter with revenues coming in at $8.54 billion, up 8% Y/Y, and beating estimates by $1.59 million. Q3 EPS came in at $3.73, beating estimates by $0.25. Subscriber growth was the theme of the quarter, as the company looks its password-sharing crackdown to the next level, with net new subscriber additions coming in at 8.8 million, significantly exceeding expectations and comfortably beating the 2.4 million net-adds during the same period last year.
The company also managed to generate operating margins of 22.4% on account of strong revenues and content timing.
Management also provided strong guidance, with fourth quarter revenues now expected to come in at $8.7 billion, up 12% Y/Y on a currency-neutral basis, and FY23 operating margins expected to come in at 20%, the upper end of the earlier forecast.
Actor Strikes Not Having The Impact Initially Feared
Although the writers’ strike has thankfully come to an end, the actors’ strike rages on, which is having an adverse impact on studios and streamers alike. However, thanks to NFLX’s astute licensing agreements, these strikes are not having as much of an impact as initially feared. For instance, according to NFLX management, based on data from Nielsen, the legal drama Suits, which NFLX has licensed for streaming, broke viewing records in July and generated 1 billion of viewing hours for the company globally. This is despite the fact that the show wrapped up in 2019 and was also available on other streaming devices prior to NFLX licensing it.
Then there’s the company’s move into animated movies, which are protected from the strikes. During the quarter, the company entered into a multi-year agreement with Skydance Animation, under which, Skydance will develop animated movies for NFLX starting in 2024. Furthermore, the company has already lined up two animated movies, Leo starring Adam Sandler and the sequel to the global superhit, Chicken Run.
A combination of NFLX’s licensing content and animated movies should protect the company from the actors’ strike, which doesn’t appear to have an end in sight. In addition, the final season of The Crown, and the reality competition show Squid Game: The Challenge, should also drive user engagement.
Price Increases Should Buy Netflix Time to Optimise Its Ads Business
One of the key highlights from NFLX’s Q3 was the company’s plans to raise prices for some of the tiers in select countries. While the company’s ads-tier prices will remain unchanged, the Basic and Premium tiers will see their prices increase in the U.S., U.K., and France. The success of the company’s password sharing crackdown could be a major factor behind this move, although the management didn’t detail the exact reasons behind the move.
The price increases should also allow the company more time to optimise its ad-business. While the company’s ads business had a decent performance in Q3, with a nearly 70% increase in ads membership, and ads memberships now account for nearly 30% of new sign-ups. While this is a decent start, management did mention that ads business is not going to be material for FY23 and that their immediate priority is to optimise this business so that “Netflix becomes an essential buy for advertisers.” The management also announced that they are planning to invest in their own sales team and technical infrastructure. The company also replaced Jeremi Gorman with company veteran Amy Reinhard as the new ad chief.
So, while the ads business is likely to take longer before it starts having a material impact to the business, the price increases should help the company to generate meaningful profits in the meantime.
Netflix Reminds Investors About its Gaming Ambitions
Finally, NFLX also reminded investors during the quarter about its ambitions to succeed at gaming. The company announced that it has plans to release games based on popular shows such as Squid Game and Wednesday. Furthermore, reports suggest that the company is also considering licensing Grand Theft Auto from Take-Two Interactive. Next month, Netflix subscribers will also be able to play the popular strategy game Football Manager 2024 Mobile edition.
Based on its plans, it is clear that the company is planning to employ the same strategy that it uses for its content library, for gaming as well. While this is likely to be a more challenging endeavour, given that NFLX will have to compete with the likes of Microsoft (MSFT) after it closed its $75 billion acquisition of Activision Blizzard, the updates provided by the company does indicate that the company is taking gaming seriously and sees it as a meaningful revenue diversifier in the coming months.
Valuation
|
Forward P/E Multiple Approach |
|
|
Price Target |
$460.00 |
|
Projected Forward P/E Multiple |
33x |
|
PEG Ratio (NTM) |
1.32 |
|
Projected Earnings Growth |
25% |
|
Projected FY24 EPS |
$13.95 |
Source: Refinitiv, Author’s Projections, and Company’s Q3 Letter to Shareholders
As mentioned earlier, the company now expects Q4 revenues to come in at $8.7 billion. This would result in total FY23 revenues of $33.6 billion. NFLX management now expects FY23 operating margins to be 20%, which results in operating income of $6.72 billion.
I have assumed non-operating expenses for the company to remain unchanged at $380 million and the tax rate of 22%, which results in net income of $4.94 billion. According to Refinitiv, the number of shares outstanding now stands at 443.15 million, which translates to an FY23 EPS of $11.16.
The company currently trades at a forward P/E of 33x and a forward PEG ratio of 1.32, which suggests an EPS growth rate of 25%. This subsequently results in an FY24 EPS of $13.95. At a forward P/E of 33x and a FY24 EPS of $13.95, we get a price target of about $460, which represents an upside of approximately 15% from current levels.
Risk Factors
As I mentioned last time I discussed NFLX, the company is not fully immune to the ongoing actors’ strike. A swift resolution to these strikes continues to be a crucial factor to NFLX’s plans for long-term growth.
Then there’s the company’s ad business, which the company is still trying to figure out. The build-up of this business has been slower than anticipated, and while ad-tier subscriptions are on the rise, how the company manages to convince advertisers remains uncertain.
Finally, the company’s entry to gaming will not be easy, despite the massive potential. NFLX had the first movers’ advantage in streaming, but in gaming, it is likely to face a lot more competition given that there are far more traditional, established players in the space.
Concluding Thoughts
Q3 was all about subscriber growth for NFLX. While revenue and EPS marginally beat expectations, the net subscriber additions came in much better than expected, suggesting that the company’s password sharing crackdown is going much better than anticipated. The company’s astute licensing deals and its increased focus towards animation movies is likely to shield it from ongoing actors’ strikes.
From a valuation perspective, improved future operating margins as a result of upcoming price increases, makes the stock undervalued at current levels. The stock, despite being up 36% YTD, has taken a beating in recent times. On the basis of its third quarter performance and the company’s plans for the future, the recent decline in its stock offers investors a unique opportunity, in my opinion, to buy a high quality company relatively cheaply.
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