Netflix's (NFLX -0.83%) results for the first quarter of 2022 shocked its shareholders.
The company said it lost 200,000 subscribers -- its first such decline in more than a decade. And because of the turmoil created by Russia's invasion of Ukraine, Netflix warned it could lose 2 million more paying customers in the second quarter.
The results compelled many investors to sell their stock, plunging to its lowest price since 2017.
But overlooked by most, the streaming giant divulged two "golden nuggets" of valuable information:
- Offering a free ad-supported streaming channel, possibly in the fourth quarter, according to leaked internal memos, and comments from CEO Reed Hastings.
- Executives told analysts they expect their company to hit an important financial milestone this year, generating consistent positive free cash flow (FCF) for 2022 and beyond.
As unlikely as it might sound now, with the stock down 75% from last year's highs, those announcements could turn the stock into the kind of holding often prized by long-term investors like Warren Buffett.
The anatomy of a "Buffett Stock"
Most of the companies in Buffett's Berkshire Hathaway portfolio -- think of Apple, Disney, Coca-Cola, and others -- sell products or services that change little from year to year. But customers keep coming back for more.
As a result, most of Buffett's businesses have steady profits, but also low debt while generating a steady stream of excess cash that can be funneled back into the company for future growth.
Then there's Netflix.
For most of the past decade, the company spent heavily on cutting-edge shows and movies. In turn, those programs attracted millions of new subscribers and generated a steady stream of profits.
But the flow of money from subscriber fees was never enough. Over the last 10 years, Netflix annually spent an average of $860 million more than it took in.
The company made up the rest by tapping the bond market. Between 2015 and 2020, Netflix raised its long-term debt levels by 600%. As of the first quarter of 2022, it still owed $14.5 billion to bond investors (more on that below).
For Netflix, the problem is that once a hit series ends its run, the company has few options (aside from a tiny stream of DVD sales revenue) to rerun the same show to a new audience and get paid for it.
An ad-supported streaming channel gives Netflix a "Buffett-style" way to generate recurring revenue long after a program loses its buzz-worthy status. According to some estimates, a Netflix "free channel" could generate as much as $2 billion to $3 billion a year in additional revenue, and that's just for starters. That's money the company can earmark to pay down debt or buy back its own stock.
Recent studies point toward massive growth for ad-supported streaming. The market grew by more than 20% each of the last two years, and will likely triple in size to more than $31 billion by 2026.
For Netflix, one way to compare the possibilities is to look at the average revenue per subscriber -- $14.91 -- according to its first-quarter 2022 results. By contrast, Roku (ROKU 1.88%) a free ad-supported streaming competitor generates average revenue of $42.91 per user or nearly three times as much.
Will 2022 be the financial turning point?
Even so, Netflix executives say their company is already on track to achieve another Buffett-worthy milestone this year: consistently positive FCF.
During the company's first-quarter 2022 conference call, chief financial officer Spencer Neumann told analysts "We'll [have] positive free cash flow this year...and we'll continue to build on that in the years going forward."
Why is that a big deal?
Companies that generate lots of cash year after year like Walmart, Exxon, and other blue-chip companies garner "investment grade" credit ratings. So they have very low borrowing costs.
As successful as Netflix is as a company, its bonds are still rated as junk by analysts at Moody's.
But in a nod to Netflix's growing financial strength, the credit rating firm said in April it will likely raise Netflix's bonds to investment grade in coming quarters as it demonstrates "new levers to grow revenue and free cash flows."
What About Netflix Stock?
Netflix shares will likely continue to be weak in the near term. But the company is still nicely profitable.
Analysts expect the company to post slightly lower earnings of $10.94 a share this year about 3% below 2021. Some of that decline is due to increased competition for new subscribers from streaming rivals like Disney, Paramount, and others. Netflix also lost Russia as a source of new subscribers because of the war in Ukraine.
Nonetheless, if we divide the price of Netflix stock (around $170 at the time of this writing) by the company's projected 2022 annual profits, it gives the shares a price-to-earnings ratio of 15 -- its lowest valuation level since the dark days of the 2008 U.S. financial crisis.
Looking to 2023, analysts expect Netflix's profits to resume a pattern of double-digit percentage annual growth, hitting $12.62, and rising still further to $15.30 in 2024.
If we put it all together, the company's financial background is steadily improving, alongside the promise of an ad-supported free channel by late this year.
Combine those developments with the sharp drop in the share price to "value stock" status, and Netflix could eventually attract a lot more attention from investors, Buffett among them.