The investment thesis for Netflix (NFLX 0.39%) has changed dramatically over the last year. With falling subscriber numbers and the development of an advertising platform, Netflix's business model is changing. As a result, the stock fell nearly 70% from its all-time high in November 2021.
Is there any reason investors should own Netflix stock, or are the company's best days behind it?
The bull case: Password sharing and its ad-supported platform are deployed smoothly
During its second quarter, Netflix lost 970,000 subscribers, but it wasn't nearly as many as the 2 million management projected in its first quarter. Despite falling subscribers, Netflix's revenue rose 8.6% year over year (YOY). This growth is possible because the average revenue per membership grew in the U.S., Canada, and Latin America.
Growth in the Latin American region is critical because that's where Netflix is testing the monetization of account sharing. With more than 100 million households sharing passwords versus the 220 million total subscribers worldwide, there's a lot of unrealized revenue Netflix is attempting to capture. The odds of converting every account are low, but many may pay a small fee to maintain access to Netflix's content library.
Additionally, Netflix has been working on its ad-supported platform, which could help it regain some of its lost customers. A standard Netflix plan (two screens and HD streaming) costs $15.49 per month, making it one of the most expensive streaming platforms. A lower-priced, ad-tier platform will likely be priced around what other streaming services charge, but Netflix has to be careful not to cannibalize some of its existing full-price customers.
It won't be easy, but if Netflix can get its lower-tier platform correct and not lose too many customers from monetizing password sharing, it will see an impressive sales bump. In turn, profits will rise, further exaggerating Netflix's relatively low valuation of 19.6 times earnings.
Management believes things are already looking up for the business as they forecasted 1 million net subscriber additions for Q3. If Netflix can meet this expectation and show progress on its two large initiatives, Netflix's stock looks primed for a bull run.
The bear case: Netflix's initiatives backfire
Netflix is no longer alone as a streaming service. Consumers have many options, and nothing stops them from canceling one month only to restart their subscription when their favorite show releases a new season. Unfortunately, this rotation could spell disaster for Netflix's ad-supported platform.
First, full-price users may downgrade and deal with the occasional commercial. This choice would allow them to use the money they save to subscribe to another service. They would still be paying customers but would not generate nearly as much revenue. Second, if the rotation practice continues, consumers would be tempted by the lower-priced tier. Neither of these scenarios is good for Netflix and could cause its cash flow to drop.
Cash flow is vital for all businesses, and with only $13 million in free cash flow this quarter, this metric is relatively low for a mature business. With teetering free cash flow profitability, Netflix is in a precarious situation as the economy looks primed to head into recession territory. Furthermore, its balance sheet isn't the cleanest, with net debt of $8.5 billion.
Netflix could ease its content spending to boost this number, but then it would cut off its streaming service's lifeblood.
Management may have given upbeat subscriber numbers for Q3, but its financial projections were less impressive. With revenue forecasted to rise 5% YOY and operating profits declining 29% YOY, investors aren't excited about owning the stock. This sentiment is reflected in its 19.6 times earnings multiple, but if Netflix struggles to roll out its new initiatives, this number could drop even further.
The bear and bull case for Netflix can be boiled down to how well the company does with its new ad-supported platform. This rollout could make or break Netflix, which makes me want to stay far away from the stock. If it works, there's solid upside for Netflix's stock. But if it doesn't, Netflix could have a significant problem on its hands.