Netflix Inc. (NFLX, Financial) has discovered substantial support after the company's second-quarter earnings report beat analysts' bottom-line estimates. However, despite its profitable quarter, the company's subscriber growth continues to wane; thus, an earnings beat alone is not much to celebrate.
Nevertheless, Netflix has unveiled a plan to add advertising revenue to its business model, which could propel the stock back toward stardom.
Subscriber dilemma
Netflix lost an additional 970,000 subscribers in its second quarter as factors such as password sharing and intensifying competition have thrown numerous challenges into the company's path.
In my opinion, the platform's password sharing issue is transitory as the company is diligently working on solutions to improve its password protection security. And although the password protection security might not be foolproof, it certainly will allow it to buy time while seeking longer-term solutions.
Netflix's main long-term challenge is the competitive environment it finds itself in. The company was early to market with its streaming service, which allowed it to capture most of the market early on. However, as time has passed, the streaming giant has started to face competition from other big players, including The Walt Disney Co. (DIS, Financial), Amazon.com Inc. (AMZN, Financial), Apple Inc. (AAPL, Financial) and Warner Bros. Discovery Inc.'s (WBD, Financial) HBO.
Furthermore, the streaming business does not have very high barriers to entry, so it is unlikely we will see a monopoly form. Therefore, Netflix will probably have to participate in a fragmented market in the coming years.
Potential advertising revenue
Although its subscription business seems to have reached its peak, Netflix has an opportunity to leverage its platform and monetize advertising space. After releasing its second-quarter report, the company announced it plans to incorporate advertising into its business model with an "ad-supported tier" offering.
The global digital advertising market is projected to reach an annual addressable size of $876.1 billion by 2026 at a compound annual growth rate of 7.7%.
Source: Statista
As it is an established company with existing traction, Netflix has a key advantage in the ad space, meaning it is likely to grow its ad revenue much faster than the industry's 7.7% growth rate.
It remains to be seen whether ad revenue can restore Netflix's embedded growth, and only time will tell. However, it is clear that Netflix is developing the necessary strategies to reignite its long-term growth trajectory.
Valuation
After losing more than 60% of its market value since the turn of the year, it is clear Netflix has entered undervalued territory. The stock is undervalued relative to its earnings-based discounted cash flow, which values shares at $387.11, and its price-sales ratio is trading at a normalized discount of 65%, implying the company exhibits relative value.
Lastly, Netflix has gathered momentum lately as its trading above its 10- and 50-day moving averages, suggesting investors have reinstated their interest in the stock.
Concluding thoughts
Netflix's stock is tremendously undervalued after an overblown year-to-date drawdown. The stock exhibits tremendous earnings-based free cash flow potential and is undervalued on a relative basis as the market underscores its price-sales ratio.
Moreover, subscriber losses are softer than initially feared, so the company's pivot into the advertising space could reignite its embedded growth.
