Netflix: Weakening Subscribers Cause Bearish Tilt (NASDAQ:NFLX)

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Netflix (NASDAQ:NFLX) reported revenue growth of 10%, which was slightly below consensus expectations and EPS that was above. However, the biggest disappointment came from global streaming paid memberships declining 200k compared to Q1 and the company guiding to another 2 million decline in Q2.

The company noted that longer-term, their goal is to sustain double-digit revenue growth and expand margins. However, over the coming quarters, we could see revenue growth remain sub-10% as net subscriber growth comes under pressure. Add on a competitive streaming landscape and it’s no surprise the stock is indicating down 25% after-hours.

Netflix price chart
Data by YCharts

For now, I believe long-term investors should wait to buy this dip. This quarterly earnings will serve as a clearing event as investors re-establish their longer-term expectations around both revenue growth and margin expectations. I believe margins will remain under pressure as Netflix will likely need to reinvest significantly in order to produce high-quality content and further penetrate their paid memberships.

From a valuation standpoint, the company’s multiple has pulled back a lot, though expectations have significantly come down. The stock is currently indicating down over 60% from all-time highs, though I believe long-term investors should hold out for a stock closer to $225 before buying this dip. Increased fears around subscriber growth trends and a weakening global macroeconomic environment (possible recession fears, stronger U.S. dollar negatively impacting international revenue, Russia/Ukraine war) could cause negative sentiment to hold for quite some time.

Q1 Earnings Review and Guidance

Revenue during the quarter grew 10% yoy to $7.87 billion and missed consensus expectations by ~1% (missed by ~$70 million). While the revenue miss is not the end of the world, the biggest disappointment was global streaming paid net additions actually declined by 200k, missing guidance by 2.7 million.

While the company acknowledged that the suspension of their service in Russia and winding-down of paid memberships resulted in 700k impact on paid net additions, they should have significantly missed expectations.

Operating income during the quarter slightly grew to $1.97 billion, up from $1.96 billion in the year-ago quarter. However, operating margins fell to 25.1% (from 27.4% in the year-ago quarter), which I believe is a factor of both currency headwinds as well as increased investments to sustain revenue growth and develop new content.

Netflix quarterly free cash flow

Netflix

One positive note during the quarter was the free cash flow improved to $802 million during the quarter, up from $692 million in the year-ago quarter. Over the past year, the March quarter has been the only quarter with positive free cash flow, which is more of a factor of the timing of working capital and investments related to seasonality. While this is a positive sign that free cash flow is improving, I believe investors will have a heightened focus on improvement over the coming quarters. Netflix has needed to invest billions over the past several years to develop content and with the streaming market becoming more competitive, it may take increased investments to grow their market share.

Netflix quarterly results and guidance

Netflix

The company also provided guidance for the upcoming Q2, which was rather disappointing compared to consensus expectations.

Revenue growth is expected to be 10% to $8.05 billion, which was below expectations for $8.22 billion. The impacts of Russia operations winding down are impacting growth, though this was well known heading into the quarter. Q2 EPS is expected to be $3.00, which was only slightly below expectations for $3.04.

The most disappointing guidance metric was global streaming paid net additions are expected to decline 2 million compared to Q1, resulting in an estimated ~219.64 million subscribers. I believe this will be a large overhang on the stock for the next quarter as investors will weigh growth opportunities against a competitive streaming market.

Paid Subscribers Becoming an Issue?

Admittedly, global streaming net additions can be a challenging metric to forecast, especially in light of the Russia and Ukraine crisis, increased competition, and a competitive streaming industry. Even with the 700k impact from winding down their Russia operations, the net additions during Q1 were very underwhelming and their guidance for Q2 could cause investors to be cautious around future growth.

Netflix Regional Breakdown

Netflix

When looking at the company’s regional breakdown, they saw paid net membership decline in their UCAN region. In addition, the average revenue per membership only grew 5% yoy, the slowest growth in the past several quarters.

Interestingly, only the APAC region saw paid net membership grow relative to last quarter, which I believe is largely driven by the greenfield opportunity in that region.

Management also discussed some reasons why membership growth may become more challenged, which was masked a little bit during COVID as global consumers sought streaming services to keep themselves entertained during various lockdowns.

In addition to our 222m paying households, we estimate that Netflix is being shared with over 100m additional households, including over 30m in the UCAN region. Account sharing as a percentage of our paying membership hasn’t changed much over the years, but, coupled with the first factor, means it’s harder to grow membership in many markets – an issue that was obscured by our COVID growth.

In addition to their 222 million paying household base, the fact that over 100 million households share Netflix passwords puts a large ceiling on potential membership growth. If these 100 million households are not currently paying for a subscription and there are no restrictions to sharing passwords, there are no incentives for them to pay for a new subscription.

As discussed in the following section, industry competition continues to increase, meaning consumers have several options for streaming services, making it more difficult for Netflix to become the clear winner.

Competitive Industry Causing Headwinds

Since the beginning of COVID, consumers have quickly adopted the use of streaming services for entertainment purposes. As a result, competition has significantly increased with the likes of Hulu, Disney+, ESPN+, HBO, Peacock, Paramount Plus, and many others.

Share of US Total TV Time

Netflix

Netflix provided this above chart in their Q1 earnings release which demonstrates while the total streaming industry has gained share relative to total U.S. TV time, Netflix is only maintaining their share.

On top of that, Netflix recently increased some of their prices across the U.S. and Canada, as well as plans to increase pricing in the U.K. and Ireland. While the increased pricing will be an immediate boost to revenue, I believe consumers now have more options than ever when it comes to streaming services. In addition, with the fear of an economic recession on the rise, consumers may look to “pull the plug” on some of the more expensive streaming services.

Netflix Price Increases

The Verge

While Netflix’s price increases are only $1-2 more per month, it does put them near the more expensive end of comparable streaming services. The chart below was taken from a CNET article from August 2021, so it does not include the more recent price increases from Netflix, which is now around $10 per month for their basic package.

Streaming Service Price Comparison

CNET

Based on the chart above, Netflix’s most basic streaming package was already near the high end of streaming services and their recent price increase likely puts them close to the top. Increased pricing is good from a revenue and profitability standpoint, however, it also gives consumers another reason to cancel their Netflix subscription or share accounts with another user.

Yes, account sharing is not new with Netflix users, and management even called this out during the earnings call.

[Account sharing isn’t new] but when you add that up together, we’re getting pretty high market penetration and that combined with the competition is really what we think is driving the lower acquisition and lower growth

Netflix is also the first large streaming service company to report March quarter earnings and given their relatively weak guidance for Q2, it would not be surprising to see some of their competitor’s stocks react in a weak fashion.

Valuation

Since the stock reached an all-time high of around $700 in late 2021, the stock has since fallen over 60% (at the time of writing this article, NFLX was trading ~$260).

I believe the weak Q2 paid subscription guidance of -2 million decline was significantly below expectations and will cause investors to become more cautious about future revenue growth. In addition, with 100 million households sharing accounts with paid memberships, it places a lower ceiling on growth penetration potential than what may have previously been assumed.

Netflix EV to revenues, EV to EBITDA and PE ratio
Data by YCharts

When looking at valuation, the stock is currently trading at ~$260 (at the time of writing this article), which implies a forward revenue multiple of just under 4x. In addition, this implies a forward P/E of around 25x. At face value, these valuation metrics sound attractive given Netflix’s history of very strong user and revenue growth.

However, I believe times have changed and investors may start to value the company at much lower multiples given the complexity of around the global macroeconomic environment (Russia/Ukraine, potential economic recession and lower consumer spending, etc.).

Even with the 25% pullback post-Q1 earnings, I believe the weak guidance metrics and concerns around global paid net subscriber additions could weigh on the stock for the next few quarters. While we may see a dead cat bounce over the coming days, I would be cautious if the stock popped over $300. Given the current negative sentiment, I would become more bullish if the stock pulled back closer to $225.

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