Netflix (NFLX, Financial), which has had a very rough 2022 so far, saw its stock finally take a turn for thebetter, jumping by 14% on news that the company had beaten its earnings estimates for the third quarter of 2022.
The company’s stock price had previously declined by ~70% from all-time highs in November 2021. This decline was mainly driven by a subscriber loss of 2 million in the first quarter of 2022 amidst rising competition, signaling an end to Netflix's hyper-growth phase.
Management announced a series of changes to recover growth numbers, and Netflix is now showing signs of a recovery. Let's take a look at the financial results for the third quarter as well as the stock's valuation to see whether it could be a value opportunity at current levels.
Subscriber growth
Netflix added 2.41 million net global subscribers in the third quarter of 2022. This was more than double management's forecasts. In addition, this was a turnaround from the loss of 970,000 subscribers reported in the second quarter of 2022.
This spectacular turnaround looks to have been driven by the Asia-Pacific region, which made up 1.43 million of the new subscribers. North America is still “not growing as fast” as the chief financial officer at Netflix would like as it only accounted for 100,000 net subscribers. This growth was driven by strong content such as a new season of “Stranger Things,” “Monster” and more. However, the company's churn did remain “slightly elevated” compared to prior years.
Moving forward, Netflix is guiding for 4.5 million net subscriber additions and is expected to build on its momentum in the next quarter.
Financial growth
Revenue was $7.93 billion in the third quarter of 2022, which beat analyst consensus estimates of $7.837 billion. This was driven by the aforementioned subscriber growth.
The company has announced its ad-supported tier in partnership with Microsoft (MSFT, Financial). This tier is expected to launch across 12 countries in November and be popular in regions such as Latin America and Asia, when tend to have a preference for ad-supported content. Given the macroeconomic issues such as high inflation and rising interest rate environment, I also forecast this cheaper tier to be popular among households who are trying to cut costs.
However, personally, I do suspect that once customers in wealthy nations such as the U.S. remember how annoying advertisements are, they may switch back to the standard model. For comparison, Spotify (SPOT, Financial) has an ad-supported subscription tier which many users don’t stick with. I believe ad-supported content works best for shorter form and less immersive content such as that on Youtube. Overall, Netflix is doing the right thing in implementing the ads so people can have the additional option, and the company says the ad-supported tier will not lose out in revenue compared to the other options.
Back to the financials, the company announced strong earnings per share of $3.10, which beat analyst expectations of $2.13.
Netflix released figures which show the company has “higher engagement” than other competitors in the streaming industry. For example, in the U.K., Netflix accounts for 8.2% of all video viewing, which is 2.3 times Amazon (AMZN, Financial) Prime video and 2.7 times Disney's (DIS, Financial) Disney+. In the U.S., Netflix accounts for 7.6% of “TV time," which is 2.6 times Amazon and 1.4 times Disney+.
Netflix also believes that its competitors are all losing money as building a large streaming service is capital-intensive. The company estimates that the other streaming providers have combined losses of $10 billion vs. Netflix’s $5 billion to $6 billion in operating profit. If these numbers are accurate, this means Netflix is in the strongest position from a market share, engagement and financial perspective. Although, I would not worry about Amazon or Disney running out of money any time soon to continue its investment into Amazon Prime video.
Netflix generated solid free cash flow of $472 million in the quarter, up from -$106 million in the third quarter of 2021. The company also has a robust balance sheet with $6.1 billion in cash and cash equivalents with virtually no short-term debt and long-term debt of just $13.8 billion.
The company is experiencing headwinds on its international revenue from a strong U.S. dollar.
Another way Netflix is incrasing revenue is by prohibiting customers from sharing accounts. The company plans on launching a paid sharing package in early 2023. This is expected to further boost revenues as the company tracks the locations of people logging into Netflix accounts and forces them to pay extra if they are logging in from a location aside from the main account address.
Valuation
In order to value Netflix, I have plugged the latest financials into my advanced valuation model, which uses the discounted cash flow method of valuation. I have forecasted an 11% revenue growth rate for next year and a 14% growth rate for two to five years. I expect this growth to be driven by the aforementioned tailwinds (mainly the ad-supported tier and charging extra for shared accounts).
I have also forecasted the business to increase its operating margin to 27% over the next four years, and I expect the strong dollar to correct down. In addition, I have capitalized R&D expenses to increase the accuracy of the model.
Given these factors, I get a fair value estimate of $298 per share. The stock is trading at $240 per share at the time of writing and is thus ~19.5% undervalued.
Netflix trades at a price-earnings ratio of 23, which is 69% cheaper than its five-year average.
Final thoughts
Netflix is still the dominant streaming company with a strong brand. The company has recently facing subscriber headwinds and rising competition, but management has acted fast and introduced a series of new changes to improve profitability.
Streaming is a difficult business, but as Netflix had an early start, it does have a substantial advantage. Founder-led companies also tend to be more aligned with shareholder interests, which is another positive. The stock is undervalued intrinsically by my estimates and thus could be a value opportunity.
