On Jan. 20, Netflix (NFLX -0.72%) released mixed financial results for its 2021 fourth quarter. What shocked the market was management's guidance of just 2.5 million subscriber additions in the current quarter, far fewer than Wall Street's expectation of 6.9 million. The stock immediately tanked more than 20% in after-hours trading following the news.
Seeing an opportunity open up, Pershing Square Capital Management, a massive hedge fund headed by Bill Ackman, purchased 3.1 million Netflix shares at the newly discounted price. Known as an activist investor who looks to shake up a company's board of directors and strategic direction, Ackman, whose firm is now a top-20 shareholder in the company, has no intentions to do that with Netflix.
In fact, he firmly believes that this top streaming stock is an outstanding business. Let's take a look at why.
Image source: Getty Images.
Subscription business model
A business model that generates a recurring revenue stream is highly attractive to investors. It provides clarity, predictability, and visibility into the company's sales trends, and it allows for an ongoing relationship with customers. Contrast this with a business that has to win every single transaction. Netflix's aim is to get a consumer using its service, and once that person sees how remarkable the content is, they'll stick around, reducing the likelihood of a subscription getting canceled.
Ackman's firm sees Netflix's revenue as having "enormous future growth potential." Based on the market's reaction to the stock after its earnings release, many might disagree with this assumption. But Netflix does have a tremendous opportunity to gain customers in international markets, particularly India, a country with 570 million internet users. Netflix trails behind Amazon Prime and Walt Disney's Hotstar in the South Asian nation.
In the U.S. and Canada, more mature markets for Netflix, the business is relying on its proven pricing power to register growth. The company just announced another price hike, the first since late 2020. If history is any indication, Netflix will still continue increasing its membership base.
Top-notch management team
Reed Hastings helped found Netflix in 1997, and he's still involved with the business as its co-CEO. He also has significant skin in the game, owning about 8 million shares worth $3.4 billion (as of Netflix's closing price on Feb. 2). And Ted Sarandos, the other co-CEO, has been with the business since 2000, bringing unparalleled expertise in content creation.
Netflix was first a DVD-by-mail business that competed directly with Blockbuster. But the management team recognized early on that the internet was going to revolutionize how people consumed video entertainment, and they invested accordingly.
And since the release of Netflix's first original series, House of Cards, in 2013, the business has become a force to be reckoned with in Hollywood. Netflix tied a record with 44 Emmy wins last year. And the company beat all other studios by winning seven Academy Awards at the Oscars, a sign of its adeptness at producing quality content.
The chance to invest in a management team that executed major strategic shifts -- like going from renting DVDs by mail to streaming video to creating content in-house -- is a big reason Ackman loves the stock.
Economies of scale
Netflix generated $29.7 billion of revenue in 2021, and it now counts 221.8 million subscribers. No other streaming business can compete with this scale, an advantage that is absolutely necessary to succeed in this hyper-competitive industry.
Netflix spent $17.7 billion in cash on content last year, a massive figure that makes complete financial sense given its huge user base. The company's first-mover advantage allowed it to attract members early on when there was no competition. And now, it's able to spread out content costs over a large customer base. Smaller rivals would have to take on a lot of debt or resort to mergers and acquisitions to even have the chance at long-term survival.
Because of these economies of scale, Pershing Square is optimistic about the direction of the company's financial position. Netflix's operating margin, which was 20.9% in 2021, has expanded substantially over the past few years as sales and customers grow. And according to the leadership team, the business is about to start producing positive free cash flow this year. This situation means the possibility of larger share buybacks going forward, a boon for shareholder returns.
Having a well-regarded investor like Bill Ackman endorse the company is certainly a positive sign for Netflix. Based on the characteristics outlined above, you might want to consider buying the stock today.
