Streaming giant Netflix Inc.'s (NFLX, Financial) fortunes changed significantly within the course of a year.
It experienced a loss of 200,000 subscribers in the first quarter of 2022, followed by almost one million subscribers in the second quarter. This resulted in a significant drop in its share price, adding pressure when investors moved away from growth stocks due to a hawkish monetary policy and interest rate hikes.
Thankfully, the situation improved with a series of positive announcements, which resulted in Netflix adding subscribers once again by the third quarter.
In addition, its advertising business has gained momentum after a sluggish start.
Regardless of its performance, Netflix's current high valuation may be overinflated due to macroeconomic factors that have caused a slowdown in advertising budgets. This is a recurring trend as, historically, Netflix has been known to trade at high multiples. The current situation is no different.
Financials are moving in the right direction
Netflix's financial performance has been impressive over the past five years, with significant growth in gross profit, gross margin, operating income and net income. Despite a few setbacks, the company has managed to maintain its position as a leading player in the streaming entertainment industry.
From 2018 to 2022, Netflix's gross profit increased from $5.83 billion to $12.45 billion, representing a five-year compound annual growth rate of 16.39%. The company's gross margin rose from 36.89% to 39.37% over the same period, maintaining profitability while growing its revenue.
Operating income, a measure of a company's profitability from its core business operations, has risen significantly from $1.6 billion in 2018 to $5.6 billion in 2022, a five-year CAGR of 28.54%. The company's operating margin also increased from 10.16% to 17.82% during the same period, indicating that it has increased its profitability while managing its costs effectively.
Finally, Netflix's free cash flow has improved, rising from a loss of $3 billion in 2018 to $1.62 billion last year. This indicates that the company has generated cash from its operations and investments, a positive sign for its long-term financial health.
Despite facing some challenges in recent years, Netflix has maintained strong financial performance and positioned itself as a leader in the streaming entertainment industry.
The ad tier model and its near-term limitations
Netflix has demonstrated proficiency in two critical areas in recent quarters.
First, the company has taken decisive action to combat password sharing, which can potentially cause significant issues for the business. According to a Los Angeles Times report, password sharing may have cost streamers and pay-TV operators up to $9.1 billion in 2019, with estimates suggesting this figure could rise to $12.5 billion by 2024. Although Netflix has not released any specific numbers related to its lost revenue, it is evident the problem requires attention.
The second initiative Netflix implemented was a new ad-based subscription tier in the U.S., which occurred in November. According to Ampere Analysis, the ad tier model will generate more revenue from Western Europe than the U.S. by 2027. Western Europe is forecast to produce annual advertising revenue of $1.9 billion for Netflix, compared to the U.S., generating $1 billion.
Bloomberg reports that Netflix's advertising-supported service has attained momentum, with roughly 1 million monthly active users in the U.S. after its second month. In the first month alone, the user base grew by over 500%, followed by another 50% increase in the second month. Despite initial concerns about a slow start, Netflix has met its delivery targets to advertisers.
However, the ad tier's effectiveness may be challenged as Netflix moves to restrict password sharing, which will compel millions of users to either cancel their subscription or pay for it themselves. The $7 version of Netflix may be more attractive to users mindful of costs than the $15 or $20 version.
Despite these promising developments, there are near-term risks for Netflix's ad-supported model. Standard Media Index's U.S. Ad Market Tracker has released revised data showing that U.S. ad spending dropped by 12.1% in December 2022, marking the sixth consecutive month of total spending decline.
The trend in ad spending has been affected by two primary factors. First, rising operating costs due to inflation are causing budgets to shrink, with 74% of major advertisers indicating the economic downturn is affecting their 2023 budget decisions, according to a World Federation of Advertisers survey. Another significant factor affecting digital advertising is the elimination of third-party cookies, statewide privacy laws and forthcoming federal privacy legislation. The impact of Apple's App Tracking Transparency policy is also still being experienced.
Given these circumstances, Netflix may face some challenges from its ad model in the near future.
Competition might limit long-term growth
Netflix completely disrupted the entertainment industry when it introduced its streaming model, making a vast library of content available to subscribers on demand. The platform's ability to provide content without commercials was a game-changer for consumers tired of the constant interruptions of traditional TV. By offering a variety of subscription plans, Netflix catered to viewers' needs, allowing them to choose from different pricing tiers that fit their budget and viewing habits.
However, the data indicates Netflix is operating a mature business model. The average number of paying memberships for Netflix has increased from 139.26 million in 2018 to 222.92 million in 2022, representing a 9.87% CAGR. While the number of memberships continues to grow, the growth rate has slowed in recent years. Paid net membership additions have decreased from 28.6 million in 2018 to 8.9 million in 2022.
Unlike competitors Amazon.com Inc. (AMZN, Financial) or The Walt Disney Co. (DIS, Financial), Netflix is a pure-play streaming service with no significant income from other revenue streams to support its operations. Furthermore, while its rivals possess vast content libraries that they own, Netflix largely licenses its content. Although management has tried to rectify this situation by producing orginial content, it remains that its content library may not be as robust as its competitors.
Netflix's success in the streaming industry has attracted more competitors, but these competitors are also larger and wealthier. Further, they were able to learn from the company's mistakes. As a result, Netflix's role as a disruptor has diminished and it is now seen as a declining incumbent in the industry.
It also continues to charge the highest price for its platform. With the increased competition, it is challenging to see how it can raise its prices any further without risking losing even more subscribers.
Valuation remains stretched
While Netflix's financial performance has been strong, its valuation is considered high by some analysts. One way to measure a company's valuation is to look at its price-earnings ratio, calculated by dividing the stock price by the earnings per share. A high price-earnings ratio may indicate that investors have high expectations for future earnings growth, while a low ratio may suggest a company is undervalued.
Looking at Netflix's price-earnings ratio over the past 10 years, the minimum was 15.6, the median was 126.92 and the maximum was 629.53. Currently, the multiple stands at 33, which is higer than the industry median of 15.20. This means that investors are willing to pay a premium for the stock, possibly due to its strong brand, market position and growth prospects.
However, when compared to other companies, Netflix's price-earnings ratio is ranked worse than 74.13% of 572 companies, indicating there may be better valued opportunities. For example, Paramount Global (PARA, Financial) and Fox Corp. (FOXA, Financial) have much lower ratios of 12.64 and 12.11.
As such, while Netflix's financial performance has been strong, its high valuation may make it less attractive to some investors.
Takeaway
On the back of its streaming model, Netflix became a dominant force in the entertainment industry, disrupting traditional cable and satellite providers and challenging the traditional studio system. Its success also led to the proliferation of other streaming services, creating a new market for streaming media and revolutionizing how people consume entertainment.
Netflix has achieved exceptional financial success, establishing a global brand. However, this success has not gone unnoticed by wealthier competitors, who have studied its operating model and made necessary adjustments. Among these competitors, Disney has found particular success with its streaming platform.
Given the intense competition and the challenges facing Netflix's ad-supported model in the near term, there is reason to believe the company is overvalued. This suggests there is room for its stock to decline in the coming weeks or months.
