Netflix Stock: De-FAANGed, But A Bargain Once Again (NASDAQ:NFLX)

Netflix Reports Drop In Quarterly Earnings

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Thesis

Although 2022 has proven to be a very challenging year for stocks so far, Netflix, Inc.’s (NASDAQ:NFLX) >70% crash from ATH has been nothing short of spectacular. Yes, the $300 billion market capitalization was quite obviously an overvaluation. But the company’s current market capitalization of slightly above $80 billion is equally obvious: too pessimistic. In my opinion, Netflix will continue to grow attractively for years to come, although likely at a significantly slower pace. Furthermore, the advertising-supported strategy might be more attractive than investor response suggests.

Personally, I see Netflix as a buying opportunity. Based on a residual earnings framework – anchored on analyst consensus estimates – I calculate a fair implied share-price of $249.58.

Is Netflix cheap?

Trading at a forward P/E of x16.58, Netflix is trading in line with the S&P 500 Index. However, just merely looking at P/E doesn’t fully capture an investment opportunity, since the metric doesn’t really account for a company’s expected growth.

For example: let us consider two stocks that both trade at a x10 P/E. One stock (stock A) will grow at 5-year CAGR of 3% (nominal GDP growth), while the other stock (stock B) is expected to grow at x3 nominal GDP, at a CAGR of 9%. How will their relative valuation differ after the growth period? After 5 years, stock A will trade at a x8.6 P/E, while stock B will trade at a x6.5 P/E. Thus, simply judging a stock based on P/E might cause investors to miss out on a bargain.

That said, the PEG ratio is broadly considered as an informative metric to judge a stock’s relative expensiveness, taking into account both P/E and expected growth. The ratio is calculated as a P/E divided by 3-year CAGR expectation. Most notably, if we calculate the PEG ratio for both Netflix and S&P, we will find that Netflix 1.36 PEG is approximately 70% cheaper than the broad market’s x4.16.

PEG Ratio Netflix vs SPX

Analyst Consensus EPS; Author’s Calculation

But is 12% growth reasonable?

In my PEG calculation for Netflix, I anchor on a 3-year CAGR of 12%–as estimated by analyst consensus forecast (Source: Bloomberg Terminal, July 2022). But, is 12% growth for Netflix reasonable? Yes, I do believe so. First, note that from 2018 to 2021 Netflix has grown earnings at 114%, 54%, 47% and 85%. Thus, a 12% growth for the next 3 years would imply a significant 80% slowdown as compared to Netflix’s track-record of increasing earnings for the recent past. This is a unreasonably pessimistic outlook, in my opinion. That said, there are two major levers where Netflix could squeeze EPS growth.

First, Netflix could crack-down on password sharing within households. The company estimates that currently 100 million users are avoiding a subscription through the usage of a shared account. If Netflix were able to charge an extra $3 dollar for password sharing accounts, the company would add approximately $3.6 billion to net-income ($3 * 100 million subscriber * 12 month). Most notably, this could achieve 12% CAGR without the need for any market expansion.

Second, Netflix ad-supported subscription makes more economic sense than the market narrative implies. I assume that Netflix could generate approximately $5 monthly from ad-supported subscribers, which is a very conservative assumption in my opinion. If Netflix were to add only around 58 million new subscribers, the strategy could generate approximately $3.5 billion in incremental earning. Again, this would support a 12% CAGR expansion. Notably, competitors including Disney (DIS), Hulu and HBO have relied on ad-supported subscriptions for quite some time–supporting the value thesis of the ad-based monetization strategy.

In any case, I see that Netflix’s 222 million subscriber number is closer to the industry’s maturation point than what has been expected for a long time. Netflix’s disappointing Q1 2022 numbers suggest that my concern might be correct. While Netflix has long targeted 1 billion subscribers, the company may now shift from user expansion to user monetization. In my opinion, this is something that investors should appreciate, not punish.

Residual Earnings Valuation

Now, let us try to find a reasonable target price for Netflix shares. Personally, I am a big believer in valuing a company based on a residual earnings framework (1), anchored on analyst consensus for the next 2-3 years (2) and with reasonable/conservative WACC and TV growth assumptions (3). That said, my assumptions are as follows:

  • To forecast EPS, I anchor on consensus analyst forecast as available on the Bloomberg Terminal ’till 2025. In my opinion, any estimate beyond 2025 is too speculative to include in a valuation framework. But for 2-3 years, analyst consensus is usually quite precise.
  • To estimate the cost of capital, I use the WACC framework. I model a three-year regression against the S&P to find the stock’s beta. For the risk-free rate, I used the U.S. 10-year treasury yield as of July 01, 2022. My calculation indicates a fair WACC of approximately 8%. I adjust upwards to
  • For the terminal growth rate, I apply expected nominal GDP growth at 3%. Why I believe Netflix could definitely achieve higher TV growth, I want to be conservative in my estimation. And besides, any estimates and arguments beyond two/three years are too speculative.
  • I do not model any share-buyback–reflecting a conservative valuation.

Given my assumptions, the residual earnings framework returns a base-case target price for NFLX of $249.58/share, implying that Netflix stock could have approximately 40% upside.

NFLX valuation

Analyst Consensus EPS; Author’s Calculation

I understand that investors might have different assumptions with regards to Netflix’s required return and terminal business growth. Thus, I also enclose a sensitivity table to test varying assumptions. For reference, red-cells imply an overvaluation as compared to the current market price, and green-cells imply an undervaluation. For me, risk/reward is clearly skewed to the upside.

NFLX valuation sensitivity table

Analyst Consensus EPS; Author’s Calculation

Risks

In my opinion, Netflix shares have been significantly de-risked–given that the company now trades at very reasonable multiples. However, investors should note a few risks. First, investors should monitor competitive forces in the streaming industry. While Netflix has a strong position in the streaming industry, the company’s competitors including Disney, Amazon (AMZN) and Warner Bros. Discovery (WBD) are arguably equally strong. Moreover, while the “streaming war” may be easing, the economics of the industry are still surrounded by uncertainty.

Secondly, much of NFLX’s share price volatility is currently driven by investor sentiment towards stocks–and growth assets in particular. Thus, investors should expect price volatility even though Netflix’s business outlook remains unchanged. Finally, inflation and rising-real yields could add significant headwinds to NFLX’s stock price, as the higher discount rates affect the net present value of Netflix relatively long-duration cash flow profile.

Conclusion

Whenever a stock is down 70%, I am eager to research if there is a value thesis. I believe there is one with Netflix. While the stock has certainly traded at very rich multiples in the past, investors should not disregard the company’s value simply because the stock sold off 70%. Or in other words: I believe the stock’s crash was less provoked by bad business performance, but more by an extreme overvaluation that needed to be corrected.

Investors should not forget that Netflix stock has crashed more than 70% before–twice. And each time, the crash has proven an amazing bargain opportunity.

Netflix drawdowns history

Data by Y-Chart; Source A Wealth Of Common Sense

I believe Netflix stock is a bargain opportunity once again. Thus, I give a Buy recommendation–with a $249.58/share target price.

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