Netflix (NFLX 1.05%) stock has notched a nice little rally in the wake of the company's second-quarter 2022 earnings. Share prices rallied some 25% in the days following the quarterly report. Global subscriber losses and resulting revenue didn't fall as much as expected, and shareholders were happy to chalk it up as a win.
But Netflix isn't out of the woods (at least not yet). Blame the U.S. dollar's historic run-up against most other currencies. For Netflix's business model, a strong U.S. dollar is putting a serious dent in profitability. Until this headwind abates, the streaming pioneer stock isn't nearly as cheap as it may appear.
The devastating currency exchange effect on operating profit
In spite of a 1 million paying subscriber net loss from the previous quarter, Netflix's revenue actually increased 8.6% year over year in Q2. More subscribers from the year prior and higher subscription fees helped the top line edge higher.
However, foreign currency exchange rates reduced realized revenue by $339 million in the last quarter. Excluding currency exchange, Netflix sales would have been up 13% year over year.
Shareholders have the dollar to thank for that. How so? In an attempt to tame inflation, the U.S. Federal Reserve has been aggressively hiking interest rates to cool off the economy. A side effect of the Fed's action is a strengthening U.S. dollar against other currencies. In fact, the dollar's fast rise has been nothing short of historic as the Fed has gone from near-zero interest rates to nearly 2% in very short order. As of this writing, the dollar is up some 15% against the euro in the last year and is up 25% against the Japanese yen. It's a similar story for other foreign currencies.
When a multinational company like Netflix makes a sale overseas, it later has to convert that foreign currency back into U.S. dollars for financial reporting and for paying expenses. When the dollar is up against that foreign currency, it lowers the value of the original sale. This is a headwind that has been impacting many other companies as of late.
Currency exchange is particularly problematic for Netflix, though. Because of the negative exchange rate effect (plus $150 million in employee severance and real estate impairment costs), a modest year-over-year revenue gain in Q2 added up to a nearly 15% year-over-year decline in operating profit to $1.58 billion. Resulting free cash flow (operating profit minus capital expenditures) was just $13 million.
The outlook for the third quarter is even worse because Netflix says 60% of its revenue comes from international markets but nearly all of its expenses are in U.S. dollars. As a result, a forecast 5% year-over-year increase in revenue is expected to translate into a 29% year-over-year decline in operating profit (versus what would be a 3% decline when excluding currency exchange). That implies operating profit will be just $1.25 billion in Q3.
The headwind could later reverse, but mind the business model
Of course, this foreign currency exchange issue could flip to a positive at some point. If the Fed stops raising rates later this year or next -- or if the Fed is even forced to start reducing interest rates again if the economy hits the skids -- the dollar could give back some of its gains against foreign currencies. In that instance, Netflix could get a revenue and profit boost.
But for now, currency exchange rates are proving to be a drag on what's already a low-margin business model. On a free cash flow basis, Netflix has generated a meager $140 million profit in the last year on revenue of $31 billion. (Net income was $5.1 billion in the last year, far higher because of financial accounting related to its content creation spend in which it realizes these costs over time, versus as a lump-sum up-front payment for content when reporting free cash flow).
In other words, Netflix may not be the cheap stock it appears to be (20 times trailing-12-month earnings per share as of this writing). With the U.S. dollar sharply higher than it was a year ago, profitability looks poised to take a big hit at exactly the wrong time.