Is Netflix Running Out of Room to Grow?

Despite solid recent financial results, Netflix (NFLX -0.56%) shares have dropped 27% over the past year over concerns about decelerating subscriber growth. In this episode of "3 Minute Stocks Updates" on Motley Fool Live, recorded on Feb. 2, Fool.com contributor Toby Bordelon and host Brian Feroldi discuss if investors are right to be worried about the company's future growth prospects.

Toby Bordelon: The big story with Netflix, I think, is spending on content. Content assets remain their biggest asset on the balance sheet. Capital asset, capitalized costs of creating and acquiring content, and debt is also significant. They actually have more debt than their equity and capital structure on their balance sheet right now. Revenue was up 16 percent for the fourth quarter. That was nice. But the cost of revenue, which are these costs mainly related to creating and acquiring content, up 24 and 1/2 percent. You can see the problem there. Cost growing faster than revenue is a concern. In fact, in their earnings report for the fourth quarter, they said, they didn't do any share repurchases in Q4 because they used cash to fund an acquisition. This was the Roald Dahl story, which they're showing on Netflix. That's a sign of potential issues. They can't acquire the content and return cash to shareholders right now. They can't do everything we want to, at least not right now, because of these spiraling content costs. Lower revenue growth and higher content means, lower operating costs. As we see here, we're seeing their lower operating margin. We're seeing this operating margin. Notice, in the pandemic, it went a little bit higher, but it's consistently been at, or above that 300 basis points line. For 2022, they're estimating it's going to drop to 20 percent, 19 percent. Actually, come down, dropping into that 300 basis points growth line for the first time. That is a potential concern. That's what I think is weighing on the stock. If you look at their free cash flow, there's not a lot of excess right now. Their operating cash flow is all being pumped back into content acquisition. They're still self-funding for now, but that's going to be an issue, potentially, if there's not any other cushion. The other big concern here is slowing growth. We see here, management in 2022 is guiding to the lowest net additions in four years. Now [2020] was huge. 2021, we saw some expected pullback. If you put those two together, you get right about that 2018-2019 level. The concern is that, maybe from 2022 forward, we're back just at a lower steady state. We're not going to get back to that growth we had before the pandemic. Again, that's weighing on the stock. But there are plenty of untapped markets. They did just pursue a price increase. There is the potential for growth return. I'm just wondering if, you can't grow rapidly forever. There are only so many people in the world. Maybe we're starting to see some of that play out right now.

Brian Feroldi: Thanks, Toby. Financially, the quarter was fantastic for Netflix, but the market didn't care. The only thing that market cared about was subscribers and subscriber growth. The numbers there were, as you put it out, disappointing. Do you think that that means that the company is running out of room to grow?

Bordelon: I think, that remains to be seen. That's my honest answer. I'm a little concerned that it might be that latter. I think, it might be actually running out of room to grow. As I said, they're a finite number of households in the planet. At some point, growth is going to slow. We may be nearing a saturation point, I think, in terms of market penetration. They need to find maybe another area to go into. Gaming might be the answer there, or maybe shareholders need to accept that is a mature company. Now, the problem with that, if you say this is a mature company, when I hear that, to me, that means a company that's generating decent cash flow in a steady state. Netflix isn't there right now because of the high content costs. Their cash flow is going to content creation, content acquisition. I hope growth isn't over, I really do. I think they need to get to a better place in terms of their revenue versus their expenses to create that decent cash flow before we get to that low-growth steady state. I think, it's a wait-and-see the scenario right now. We'll see what the next few quarters bring.

Feroldi: For sure. One thing on the call that I took particular interest in was, they blow up prices significantly in India because they were having traction in there. That might be a major source of growth for them in the future.

Bordelon: Yeah. There are certainly, like you said, maybe we are saturating the U.S., but there's a lot of world left. Maybe you see some growth in international going forward.