Perhaps the one sentence from Netflix Inc.'s (NFLX, Financial) fourth-quarter earnings call that summarized its earnings report and its 2024 outlook was how Co-CEO Greg Peters characterized the company's performance as “back to business as usual.”
The streaming giant published the earnings report for the final quarter of 2023 last week. It not only beat estimates for the quarter, but management also projected higher growth than consensus estimates.
While reviewing the company's performance, I observed that management has prioritized stronger free cash in addition to growth while also noting robust demand among paid members. This leads me to believe Netflix's stock is undervalued at current levels.
Business model recap
Netflix was founded in the dot-com era as a DVD-by-mail service, allowing users to rent its DVDs online and have them mailed to them. Over the years, the company has gone through a few business transformations as preferences in the target market evolved. Its most well-known and successful transformation to date is turning the company into the most popular video streaming platform in the world by leveraging AWS's cloud infrastructure.
The company always prioritized an ad-free experience for paying members, but as costs for everyday products and services soared in the post-pandemic era, consumer demand for Netflix's streaming subscription fell precipitously, forcing it to offer subscription plans at cheaper prices with ads. The company also leveraged another opportunity with paid-sharing by allowing family members or friends to share their Netflix account with other family members or friends for a small fee. So far, these strategies seem to have worked for Netflix.
Since it is an app-based subscription-based business, metrics such as volume of paying members and average revenue per member are important metrics to review, in my opinion, to monitor the growth prospects of the business.
Strong fourth-quarter and full-year performance
For the fourth quarter of 2023, Netflix beat revenue estimates by 1.3% at $8.8 billion. For the full year, the company's revenue trajectory reversed course back into growth mode, recording 11% year-over-year growth. But what was more interesting to me is that the company expects even stronger growth in 2024, projecting “healthy double-digit revenue growth.”
I believe a majority of the catalysts Netflix may be referring to as they project higher growth this year can be seen in the renewed durability of its subscriber numbers in the table below.
From the chart above, it is apparent the Europe, Middle East and Africa region has emerged as the top region for Netflix in terms of paid subscriber ads, growing at almost 16% on a year-over-year basis, twice as fast as the number of paid members being added from the U.S. and Canada and almost as fast as the fastest-growing region, Asia Pacifica and China, which is growing at 19% year over year. I believe much of the growth in the EMEA can be attributed to the sustained performance of Netflix's content, such as "The Crown," which drove higher net-paid member additions to its streaming platform.
However, I suspect another factor that drove the surge in paid members is the password-sharing crackdown it initiated last year. While many studies have shown a mixed impact on Netflix's revenue, I believe on a net-net basis, this actually added about 15% incremental revenue to Netflix based on this study.
In terms of operational efficiency, I observe that Netflix's management has prioritized margin expansion this year, as seen from the chart below. Management has also been guided to sustain growth in profit margins over time.
Netflix also has a history of holding debt. As of the most recent quarter, the company had around $15 billion in debt. With around $7 billion in cash, Netflix's debt position may look risky. But the company has demonstrated its ability to manage its debt, as is consistent with most large, well-managed enterprises. It has been leaning on a pre-pandemic strategy of issuing high-yield bonds to fund the acquisition and production of content that drives its entire streaming platform. But in 2022, the company announced a move away from its indebted strategy and used its free cash to fund its content plans. In the recent quarter, Netflix pleasantly surprised me by posting roughly $7 billion in free cash, which is approximately four times more than the free cash it recorded in 2022. Moreover, management projected approximately $6 billion in free cash by the end of 2024. Although that will mark a slight deceleration in the growth of the free cash, I still see this as a positive development for Netflix's debt position.
In terms of valuation, I will assume consensus estimates of margins at 24%. Netflix is guiding for 26% margins in the first quarter of 2024, but I expect that to average out over the remaining three quarters of the year. Based on management's commentary, the ad-tier subscription is a high-margin business, but will only start to meaningfully impact the top and bottom lines from next year onwards. I see the ad-tier subscription as accretive to Netflix's bottom line since it is a high-margin segment. Therefore, I expect margins to grow to 26% over the next five years.
Now given that Netflix's operating income will grow at a CAGR of 13.3% over the next five years, which is higher than the 8% average growth in the S&P500, I find it reasonable to pay a premium of 29 times forward earnings. In this case, I expect room for upside from Netflix's current valuation levels.
Risks and other factors to consider
Since Netflix is in the business of selling subscriptions to its streaming platform, I will view this as a consumer discretionary business. Most consumer discretionary businesses tend to be cyclical, as consumers alter their spending patterns based on economic cycles. One of those economic cycles was seen in 2022 as costs soared across the board, consumers cut discretionary spending and Netflix was at the receiving end with revenues declining. Although economists project the global economy will grow about 2.40% in 2024, I will expect the company to be impacted in the case of a surprise recession.
Netflix can also be impacted if it slows the roadmap of its content products. I noted earlier how global content launches had led to a sustained surge in paid members, specifically in the EMEA region. If Netflix is forced to slow down its content plans, it may impact the growth of net-paid members on its platform, which will eventually impact growth. Further, if the quality of content or content licensing worsens, paid members may cancel their subscriptions, causing revenue to decline.
Finally, streaming has become an extremely fragmented, hard-fought industry with multiple players, including Amazon Prime (AMZN, Financial), Disney (DIS, Financial) and others. Streaming platform differentiation is key here, and Netflix aims to differentiate its platform based on its strengths, which include prices and subscription tiers, content and product features. While the entire streaming industry is maturing and industry players are experimenting with different business formats, I find Netflix's strategy the most interesting. For the first time, the company announced in the earnings call, the size of its total addressable market at $600 billion, which today equals 5% penetration. Netflix's TAM has expanded beyond streaming and now includes Gaming, Connected TV and ad-tiers. Also, for the first time, management announced its ad business has been growing 70% sequentially this quarter. While these are very early days for Netflix's ad tier, I strongly feel the company is well-positioned to benefit from a robust ad-based streaming industry. Management also noted the progress it is making in building out ad-based partnership products and ad-measurement tools that eventually generate meaningful high-margin revenue contributions to Netflix's top line.
Takeaways
Netflix's recent quarter demonstrates the focus and ability of its management to deliver on long-term goals of prioritizing high-margin growth while growing free cash at the same time. The company's pivot away from its debt strategy is working while subscribers are returning to the platform. Given all of the recent developments, I see upside for Netflix.
