Netflix (NFLX -0.63%) has had quite the ride this year, and we're only one month into 2022! Amid the marketwide sell-off on interest rate fears and a less-than-stellar earnings report, Netflix is down about 30% on the year -- and that's despite a big gain in Monday's trading.
After the plunge, is Netflix a buy? Or are the concerns raised on its earnings call, as well as possible interest rate increases, reasons to say away?
Image source: Getty Images.
The concern: slowing growth, and not many answers from management
Netflix sold off big after the company missed its subscriber growth forecast for the fourth quarter, at 8.3 million versus the 8.5 million to which it guided, while also guiding to weaker-than-expected net additions in the first quarter of 2.5 million versus last year's 4 million. While many companies are now blaming the omicron surge and supply chain issues for their earnings misses, Netflix management was upfront in admitting that it didn't have any easy answers on current slower pace of growth.
On the conference call with analysts, chief financial officer Spencer Neumann said:
It's tough to say exactly why our acquisition hasn't, you know, kind of recovered to pre-COVID levels. It's probably a bit of just overall COVID overhang that's still happening after two years of a global pandemic that we're still unfortunately not fully out of, some macroeconomic strain in some parts of the world like Latin America in particular. While we can't pinpoint or point a straight line using -- when we look at the data on a competitive impact, there may be some kind of more on the marginal kind of side of our growth, some impact from competition but -- which, again, we just don't see it specifically.
Co-CEO and founder Reed Hastings elaborated, "Our execution is steady and getting better. So for now, we're just like staying calm and trying to figure out. Again, the COVID has introduced so much noise. It just wants us to give it some pause as we work on everything we've always worked on."
Obviously, with management kind of shrugging its shoulders at the subscriber miss, bearish arguments will find their way into the mix. These include the fear that perhaps Netflix's addressable market isn't as big as some thought, while another big concern is that competition from new streaming services is eating into Netflix's growth.
Reason to buy No. 1: Leadership and pricing power
Short-term worries like those listed above can be great buying opportunities, provided the company has staying power and a bright future.
I do think that's the case for Netflix. As a primary reason to buy, Netflix is far and away the leader in streaming, with global reach and economies of scale. Thanks to its first-mover status, aggressive content spending, and superb execution, Netflix is still likely the first streaming service many will buy, even as more and more streamers enter the market.
One silver lining in the earnings report was that management revealed engagement metrics remain high and churn remains low, even if net additions are harder to come by. That seems to indicate Netflix hasn't lost its luster in consumers' eyes. Perhaps that's why management just raised prices for U.S. and Canadian customers earlier this month.
Netflix has been able to raise prices in the past without much long-term damage to its subscriber growth, a big indication of its pricing power. Amid inflation concerns, companies that are able to raise prices without losing customers have a huge advantage in the environment we are seeing now.
Reason No. 2: Big fish are buying... big!
Secondly, two major investors displayed confidence in Netflix's long-term future right after the post-earnings swoon. One of them happens to be the aforementioned founder Hastings, who bought just over 50,000 shares between $387 and $393 per share, good for about $20 million.
Those purchases came just after a big buy from hedge fund manager Bill Ackman, who purchased 3.1 million shares in his fund, Pershing Square Capital Management, between Friday, Jan. 21 through Wednesday, Jan. 26. Not only did Ackman purchase Netflix stock in size, but he also sold out of his interest rate hedges in order to do it. In his letter to his partners, Ackman said that while Pershing Square expected to make even more money on his interest rate hedges as rates rise this year, he thought the long-term return potential in Netflix was even greater, so he sold the hedges to buy Netflix stock.
Ackman has scored some big wins in similar best-in-class consumer discretionary brands when they've gotten into trouble, such as Chipotle and Starbucks, so to see him go big into Netflix is a big vote of confidence, as is Hastings' $20 million buy.
Reason No. 3: It's turning free-cash-flow positive
Unlike most of its FAANG peers, Netflix has been an outlier in that it hadn't historically produced positive free cash flow. As many painfully know now, the market is reassessing these types of growth stocks with negative cash flow, with many having sold off hard over the past three months. Meanwhile, the Federal Reserve has not even begun raising rates yet. Many expect rate increases to begin in March, and that could be a further headwind for cash-burning tech stocks -- although I personally think some of those fears are overdone.
While Netflix has had positive earnings for some time now, it has yet to produce positive free cash flow since it began investing in its own content. That's because it has been spending more on new content than it has been depreciating its historical content spending. For Netflix, content spending, from an accounting perspective, is akin to capital expenditures for industrial firms. The initial outlay is capitalized on the cash flow statement, then depreciated on the income statement over the life of that content.
However, the cash flow picture should be changing this year. Netflix came close to cash flow breakeven in 2021, and now predicts positive free cash flow in 2022 for the first time in its modern era of proprietary content spending. Once Netflix pays down a little bit of debt to its target level, it will begin returning cash to shareholders in the form of share repurchases.
The good outweighs the bad
Netflix's slowing growth has likely made it a sell for momentum and growth investors, while its stock is likely not "cheap" enough to attract value-based funds, at around 38.6 times this year's earnings estimates. That kind of dynamic has likely caused the stock to fall further than it should.
While the pace of net additions is a big question mark in the near term, earnings should grow by leaps and bounds in the coming years as Netflix continues to grow revenue faster than costs, and management lowers the share count through repurchases. I think the good outweighs the bad here.
