Netflix, for me, will always be the one that got away. Streaming economics looked dicey for a long time, leading me to incorrectly conclude it would be an industry that destroys shareholder value for years to come. I severely underestimated the extent to which this is a winner-takes-most play, with Netflix emerging as the winner.
In mid-2022, the bearishness around Netflix looked like the correct view. The share price was a victim of the broader market sell-off in tech, dropping all the way down from $690 to $180. As history has taught us, that was an exceptional buying opportunity, as Netflix is trading at more than $1,200 today.
Human emotions mean we tend to get so frustrated about missed opportunities that we give up on the stock altogether. It’s really difficult to manage these biases, but it’s always worth trying to take an objective view on a stock at any point in time and deciding whether you want to own it, regardless of your particular history with that stock.
So, how is Netflix doing? These days, we don’t get any disclosure around subscriber numbers. Netflix is focused on showing the market how good it is at generating revenue rather than growing subscriber numbers, as it now has multiple pricing packages, including ad-supported tiers. The newly released second-quarter numbers tell us that revenue grew 16% year on year and operating margin came in at 34%, a casual 690 basis-point improvement vs the second quarter last year.
Operating margin has always been my bugbear with Netflix, as it is highly influenced by the amortisation of the content slate. If you can make an argument that content has a longer lifespan, then you can slow down the amortisation and boost margins. And, of course, if it turns out that people get bored with content more quickly and demand new stuff all the time, then amortisation should be faster and operating margin is probably overstated.
There are many metrics worth considering at Netflix, but one that really stood out is that total viewership hours increased by 1% year on year for the first half of the year, despite the content slate for 2025 being weighted strongly towards the second half (even more so than usual).
The mistake was in not changing my mind quickly enough when it became clear that things were going to work out at Netflix
Another useful statistic is that almost half of the viewing of Netflix originals was related to titles launched in 2023 or earlier. This gives some support to Netflix’s belief that its content has a long lifespan, which means slower amortisation and higher margins. Most of all, that means less free cash flow pressure, as the existing content library is a meaningful asset.
Indeed, the old adage of “cash is king” finds strong application here. Alas, it’s this approach that kept me out of Netflix a few years ago, as the company was particularly skilled at showing positive operating margins and little free cash flow, such was the requirement to invest in new content all the time.
Even with hindsight, I can’t fault my approach of being worried about such a situation, as most companies in that boat would turn out to be painful for investors. Instead, the mistake was in not changing my mind quickly enough when it became clear that things were going to work out at Netflix, measured by consistent positive free cash flow.
In the latest quarter, free cash flow came in at nearly $2.23bn. This is still well below operating income of $3.78bn, reflecting the extent of spend on new content. It’s up by a whopping 87% year on year though, so there’s plenty to smile about there.
And yet, the Netflix share price closed 5% lower as the market fully digested the numbers. That’s quite a response to a company that exceeded earnings estimates and raised its full-year revenue guidance. We can’t even blame the guidance around operating margin, which it expects to be 30% on a reported basis. Though this is well off present levels, the market is familiar with the significant seasonality in Netflix’s numbers when it comes to sales and marketing expenses in the second half of the year.
This suggests that the sell-off is simply a long overdue correction after a strong rally. Even after that dip, Netflix’s price/sales multiple is now higher than it was during Covid. It peaked at a mildly outrageous 14.2 recently, before dipping to 12.3. Even at the current free cash flow margin of about 20%, that’s a free cash flow multiple north of 60 — and it’s hard to see how even Netflix can continue trading at those levels.
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