Netflix is coming into a nail biter of a report. The ad tier will be under pressure in terms of how it’s performed in various regions when the company rolled it out in January. There is a report from Bloomberg that Netflix added 1 million in their first two months. An analyst noted below is expecting 1.75M total for the quarter. Overall, the goal is to reach 13M by Q3 2023.

Fundamentally, Netflix has become a different stock over the past year. In addition to the new advertising tier, which we hope is a catalyst, we own Netflix due to the underlying fundamental strength. According to analyst estimates, Netflix bottomed on revenue growth last quarter with noticeable improvement in H2 2023. The company has been transparent on how they will meet guidance on margins, including free cash flow.

The EPS is also rebounding with analyst consensus showing a 100% increase on EPS over the next two years. This is subject to change, but helps complete the picture as to why we’ve been covering Netflix closely.

Netflix is our largest position right now, thus we guard it closely. Our service is setup to show our Members what it looks like to realistically manage a portfolio. We do not provide an endless pipeline of stock tips. We carefully build positions and we carefully take gains, at times. We will gladly talk about the same stock dozens of times if it’s going to make us money.

Those who are addicted to a constant stream of information, and who are addicted to new stock tips, will get hurt in 2023. There simply aren’t that many great tech stocks in the current macro environment. If there’s anything you get from our service, I hope it’s that one important take away. 2023 is the year to hold fewer stocks, and to know them well.

Active management helps to participate in the gains. For example, to illustrate — Netflix is down (42%) from Jan 1st, 2022 and it’s up 61% from October 11th. This is why active management is well worth our time.

Buy Plan/Sell Plan – April Stock Tip:

By Knox Ridley

Between $379-$420, Netflix will be in the high-risk zone. Do not be shocked to see us cut NFLX in half if we get into that zone. If we do get there, this will be a 20% to 30% gain from when we recommended the stock for Essentials and a gain of 75% gain from our first entry in August on the Pro/Advanced side. Normally, our Essentials plan would have participated in the higher gains, but we had not launched the service yet. Our Essentials Newsletter went live around Thanksgiving.

Netflix is working on the final 5th wave of a very large degree pattern. It bottomed in May of 2022, so it has taken this pattern almost a full year to complete. Once NFLX gets into the $379-$412 region, the pattern will have met the minimum requirements for completion. We would consider that region to come with heightened risk. In fact, we expect to reduce our position substantially if we get to that price target. This will remain our primary thesis as long as price holds the $300 region. For long-term buyers, we believe the time to accumulate is not now.

What we are watching for:

• There is outsized pressure on the advertising tier given the global rollout in test regions. Although password sharing was cutoff mid-quarter, Wall Street will want to see evidence this strategic move will be accretive. Per channel checks noted below, the Street is expecting 1.75M subscribers from the ad tier, although notably, Netflix no longer reports subscriber numbers.

  Per Forbes/Bloomberg: “After a slow start Netflix ad tier has been gaining traction with U.S. subscribers. After analyzing their internal data, BloombergBloomberg reported in its first two months, Netflix had one million active users. Before its launch, Netflix had projected 1.1 million by year end 2022 increasing to 13.3 million by the third quarter 2023. Industry analysts project Netflix could eventually wind up with 30 million U.S. subscribers on its ad supported tier. The U.S. is one of the 12 markets where Netflix is now selling ads. At its most recent earnings report Netflix had 74 million total U.S. subscribers with 231 million worldwide.”

• Netflix has been cutting costs this quarter. We want to see the company maintain bottom line strength. For Netflix, sometimes misses on the bottom line are due to FX headwinds, and other times they’re due to lumpy content costs.
• Q1 is expected to be a weaker quarter for the year on operating margins with management stating “For Q1’23, we expect operating margin to be down year over year (20% vs. 25%) due primarily to the timing of content spend.” This would be 18-20% operating margin, down from a 25% margin in the year ago quarter.
• Social media has a hard time dissecting the lumpiness in the new macro. Nvidia was a target for shorts because of this, what they didn’t realize is that NVDA had bottomed fundamentally in the prior quarter. In a nutshell, if the bottom-line miss is transitory – FX headwinds or lumpy content costs – the market will be more forgiving.
• If Netflix’s management has guided correctly, the company has bottomed. I explain this more below (this depends on how management guided). Notably, this is the first quarter without Reed Hastings as CEO although the C-suite team has been working with Hastings for years on this transition.
• The guide I’m referring to from the last earnings call is this: “So, that all lends itself to our focus, which is kind of healthy growing double-digit revenue growth and accelerating that revenue growth throughout the year, expanding our – both our absolute profit and profit margin and then growing positive free cash flow.

Financials:

Per analyst consensus, the expected acceleration is the following:

Estimated Revenue & Estimated EPS:

• Q4: 1.9% Actual
• Q1E: 3.86%
• Q2E: 6.37%
• Q3E: 10.57%
• Q4E: 13.5%

On a fiscal year basis, Netflix is expected to report:

• FY2022 Actual: 6.46%
• FY2023E: 8.5%
• FY2024E: 11.9%

This is not a hypergrowth profile, rather what the market will want to see is quality growth. For our purposes, this can be roughly defined as an acceleration in growth that doesn’t come at the expense of the bottom line.

For EPS, Netflix is expected to report:

• Q3 Actual: $2.16 EPS
• Q4 Actual: $0.51 EPS
• Q1E: $2.87 EPS
• Q2E: $3.06 EPS
• Q3E: $3.30 EPS

I included Q3 since Q4 is often much lower than the other quarters. Although the revenue acceleration may be mild for growth investors, the bottom line is expected to grow well through FY2025. There’s a lot that has to happen between now and FY2025, but it’s good to see analysts have confidence that Netflix could double its bottom line over the next two years. 

Q3 Actual was $2.16 EPS and consensus from six analysts is EPS of $4.08 in Q3 Sep 2024.

Gentle reminder that FX can result in an advertised EPS number being very low/big miss. Last quarter, the $1.15 EPS was reported as $0.12. Per the write-up: “

“FX can be a lot to unpack but I believe the market is taking into account the $462 million FX remeasurement and seeing this as $1.15 EPS rather than $0.12 EPS. This is why we want to do proper due diligence (and steer clear of social media for investment research — that's an understatement) as there was some confusion over this that negatively spiraled on Twitter.”

Margins:

Regarding margins, this is what the management said in full: “We have been targeting a FY23 operating margin of 19%-20% based on F/X rates at the beginning of 2022. We now expect to deliver roughly 21%-22% operating margin on this basis (above the 19%-20% range). Rolling forward to F/X rates as of January 1, 2023, this translates into a FY23 operating margin target of 18%-20%. For Q1’23, we expect operating margin to be down year over year (20% vs. 25%) due primarily to the timing of content spend.”

• Last quarter, Netflix had a gross margin of 31%
• The operating margin guide works out to 18% to 20% margin, down from 25% in the year ago quarter.
• Due to FX headwinds, the FY2023 operating margin will be in the 18% to 20% range. The market has been forgiving FX headwinds, partly due to a global company being desirable for diversification while the United States see a weak consumer.
• The net margin can be low at first glance due to FX headwinds. It was 20% in the year ago quarter yet was 1% with FX last quarter. Without FX, it was 6.5% last quarter. This included a $462M non-cash FX remeasurement.

Cash Flow:

Cash flow for FY2022 came in at $1.6B and management guided for $3 billion in FY2023. Last year, Q1 and Q3 were very strong on FCF and Q2 and Q4 were weaker. This goes back to lumpy content spend, so investors should be prepared for this and not expect a linear path to the $3 billion.

“But that’s what plays through and then also plays through that cash flow generation that you see, where we believe with all those dynamics and managing at about the same level of cash content spend that we will have more than $3 billion, at least $3 billion of free cash flow in the year.”

The $1.6B in FY2022 compares to ($158) million for FY2021. Overall, this is a very different Netflix today as the company lost over ($3) billion in free cash flow in 2019.

The in-house moderator also hinted toward “$4 billion plus in 2024” and management did not correct her. We would need an official guide but I have this number penciled in for next year. 

The company’s gross debt is $14.3 billion and the company’s net debt is $8.37 billion or 1.3X LTM EBITDA with $6.05 billion in cash. You’ll notice the LTM slightly ticked up from 1.2X LTM last quarter. To reiterate, this is because Q4 tends to be weaker than other quarters. With the $3B in FCF expected in FY2023, Netflix can get the LTM below 1X. 

The gross debt will still outweigh cash for some time. The company has stated investors can continue to expect $10 to $15 billion in gross debt. According to the last 10-Q, the company’s next payment of $400 million is due in October of 2024.

It’s understandable if you’re scratching your head at Netflix’s debt. This is part and parcel with Netflix’s business model. The market has come to accept this over the past decade-plus. You’ll have to decide for yourself if the business model works for your risk profile.

Noteworthy:

The upfront season starts in May. We covered this in December when we said:

“The Second Chess Move is called The Upfront Season 

Every year, advertisers and agencies negotiate and sign year-long deals with TV networks as well as connected TV platforms to commit to spend an agreed amount on ads. They call this the upfront season. Last year, NBCUniversal clocked $7 billion in the upfront season and Roku grew it’s upfront spend from$500 million to $1 billion.

The 2023-2024 upfront season will take place in the late Spring and early summer of 2023.”

Reed Hastings has stepped down. Ted Sarandos and Greg Peters are Co-CEOs. Ted Sarandos became Co-CEO in July of 2020.

The revenue drivers being closely watched are the paid sharing (cutoff passwords) and the ad tier. Management stated they are expecting modest growth for Q1 on paid net adds for subscribers and a larger net add quarter in Q2. Seasonally, Q2 is a softer quarter for Netflix. Regardless, Netflix is no longer going to report on net adds. Instead, they expect analysts and investors to rely on revenue growth. 

“As discussed in previous letters, we are increasingly focused on revenue as our primary top line metric. This will become particularly important heading into 2023 as we develop new revenue streams like advertising and paid sharing, where membership is just one component of our revenue growth. So, starting with our Q4’22 letter in January of 2023, we’ll continue to provide guidance for revenue, operating income, operating margin, net income, EPS and fully diluted shares outstanding for the following quarter, but not paid membership. Similar to our regional membership disclosure, we’ll continue to report our global and regional membership each quarter as part of our earnings release.” 

Recent Headlines:

Per Bloomberg, Netflix’s ad tier reached 1M MAU after the second month. According to the report: “Most of the people signing up for the ad tier are new customers or lapsed customers, not people who immediately changed plans. The ad tier now accounts for about 20% of new sign-ups in the US, per Antenna.”

Also, per the Bloomberg report: “Netflix already has 74 million customers in the US, which means it doesn’t have that many potential new viewers. Analysts estimate the ad tier could bring in between 15 million and 30 million customers in the US, but that won’t be right away.”

My note: If it materializes, that’s some serious growth for a company that had plateaued. Reference above where management told advertisers to expect 1.75M by Q1 and Bloomberg reported up to 13 million by Q3 2023.

In February, Netflix tested lowering prices in a few regions. Per Reuters, “the price cuts took place in some countries in the Middle East, sub-Saharan African, Latin America and Asia.” See analyst note below where this was successful in India last December.

The company is scaling back on costs by restructuring its film group. Per Reuters, “Netflix will combine its small and mid-sized picture production units, cut a few jobs, scale back its output to ensure high quality titles and centralize decision-making.”

Netflix offers a video game service on smartphones and tablets, and is now bringing the video game service to televisions. Per Bloomberg: “Code hidden within Netflix’s app includes references to games played on TVs, signaling that such a plan is in motion. The code also mentions using phones as video-game controllers.” Per the report, the goal would be to attract and retain more subscribers.

Per TechCrunch, Netflix has 40 games ready to launch this year and 70 games in development.

What Analysts are Saying/Channel Checks:

“Netflix has told advertisers in the past 10 days that new sign-ups for the tier with ads had doubled in January over December, though Netflix didn't tell advertisers how many sign-ups that amounted to, people familiar with the matter told The Information's Sahil Patel. Last fall, when first pitching the ad offering, the company had told advertisers it expected the tier would draw 1.75M subscribers by the end of the first quarter, the equivalent of just 2.4% of Netflix's North American subscriber base at the end of December, the report noted.”

“Guggenheim analyst Michael Morris notes that over the past week, there have been several reports regarding Netflix pricing cuts across various markets in Eastern Europe, Latin America, and Southeast Asia, which is not the first time the company has changed prices. In December 2021, Netflix cut prices in India as it faced competition from other streaming services. Last week, co-CEO Ted Sarandos highlighted the company's success in India over the past year with viewership up 30% in 2022 and revenue increasing 25%, Guggenheim says. The firm believes Netflix is looking to extend this strategy across similar markets around the world. Guggenheim has a Buy rating on the shares.” 

“Oppenheimer analyst Jason Helfstein thinks Netflix shares are at attractive levels after dropping 22% from the post-Q4 highs on fears around higher churn from enforcing password sharing and a slower advertising launch. The company's Q1 engagement is trending weaker than the previous two quarters, but in line with Netflix's previous six-quarter average, the analyst tells investors in a research note.” 

“Citi analyst Jason Bazinet raised the firm's price target on Netflix to $400 from $395 and keeps a Buy rating on the shares. Netflix recently cut prices by 50% across 100 smaller markets, which represent 6% of its subscribers, the analyst tells investors in a research note. The firm believes "such dramatic" price reductions across so many markets "confused the Street." Citi thinks the price cuts are linked to password sharing enforcement and could boost Netflix's aggregate revenue by 1%. It says the "far more interesting question" is what Netflix will do in the 90 markets that do not have an advertising tier and have not received a large price cut. Netflix can either not enforce password sharing rules, launch an ad tier, or expand the price cuts, according to Citi. The firm updated its model to reflect the price reductions and updated current rates.” 

“JPMorgan says there has been "considerable early pushback" around Netflix's Paid Sharing launches in select international markets, which is driving greater concerns around near-term churn. Apptopia downloads data suggests increased volatility across all four Paid Sharing markets since the rollout, and the headlines may also be impacting other markets where Paid Sharing has not yet been rolled out, including the U.S., the analyst tells investors in a research note. The firm sees potential risk to Netflix's projection for more net adds in Q2 than Q1. However, JPMorgan expects Netflix to continue down the path of transitioning users away from widespread account sharing. Ultimately it expects Netflix to generate more revenue through the combination of extra members and new standalone accounts. The firm recognizes the near-term "noise" but keeps an Overweight rating on the shares with a $390 price target.”

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