Digital media veteran Netflix (NFLX -0.60%) reported second-quarter results last Wednesday. It was a mixed report with revenue below expectations but strong earnings, and the company added 5.9 million net new subscribers. These are the figures you saw making headlines on Thursday, and for good reason -- the metrics are important measures of how Netflix's business is doing.
But they don't tell the whole story. In fact, the headline figures are not what mattered the most in this report. Netflix continued the strongest streak of free-cash-flow generation in the company's history, and management made it clear that the cash profits should stay strong.
The basics of free cash flow
What's the big deal about free cash flow, anyway?
Well, this metric is a direct measure of the cash profits a company can produce after covering all its day-to-day operating costs, interest payments on loans, and other direct cash payments. It accounts for the company's capital expenses, which are investments in things like buildings, movie sets, and other bits of business infrastructure. It does not carve out pure accounting tricks such as stock-based compensation or deprecation of your long-lived assets. Those things matter to the tax collector, but they don't involve moving cash in or out of your bank accounts.
Long story short, free cash flows measure a company's actual cash profits more directly than net income does.
So when value-oriented investors are looking for long-term ideas, they generally don't measure their target companies by adjustment-prone earnings. The gold standard of tools for weighing the long-term value of any business is called the discounted cash flow (DCF) model, which estimates the amount of cash a business can produce for its investors over the long haul. It starts and ends with free cash flows, which the company can funnel into dividend payments, stock buybacks, mergers and acquisitions, and other game-changing ideas.
What's up with Netflix's cash flows, then?
Here's the fun part. Netflix delivered free cash flows of $1.3 billion in the second quarter of 2023. That's the second-highest free-cash-flow reading in the company's history, behind the $2.1 billion it collected in the first quarter.
Some might call that a fluke, but Netflix CEO Spencer Neumann doesn't see it that way.
"We're past that most cash-intensive phase of building out our original programming strategy," Neumann said on the earnings call. "So, we'll have some near-term lumpiness. But if we apply a multiyear lens, we expect a positive and growing free cash flow trajectory in the years ahead."
I highlighted the juiciest bit of that crucial statement in italics. This really is the important bit.
Netflix has a long history of positive net income and earnings per share, but again, those figures are more important to Uncle Sam than to investors. Positive free cash flows are a new development, and Netflix shareholders should celebrate the prospects of solid and growing cash profits over time.
NFLX Free Cash Flow (Quarterly) data by YCharts. The chart does not include data from the recently reported second quarter of 2023.
What these solid cash flows mean to Netflix investors today
If Netflix can deliver on Neumann's projection, reliably positive cash flows will help the company pay down a $14 billion mountain of debt and share surplus cash with shareholders through buybacks and dividends. The profit sharing has already started. Netflix spent $1 billion on buybacks over the last two quarters and plans to increase those shareholder-friendly payments from there.
I don't think Netflix will begin paying a dividend any time soon, but the company could consider paying cash for strategic buyouts one of these days. I mean deals of significant scale, far beyond the barely reportable content creator and game developer acquisitions Netflix has done so far.
And traditional value investors have a real cash profit to hang their hats on now. The management team expects free cash flows of roughly $5 billion in 2023, including a temporary boost due to lower content production costs during the writers and actors guild strikes. Things should normalize next year, followed by steady gains in the long run.
A fun DCF experiment and final thoughts
Maybe it's a bit early to start relying on discounted cash flow calculations to measure Netflix's true value, but it's a fun exercise with some interesting implications. So I plugged Netflix's projected free cash flows and Wall Street's current profit growth expectations into a popular DCF calculator, leaving everything else at bog-standard, conservative default values.
The calculator spit out a fair market value of $540 per share, more than 20% above the current price. In other words, the stock may already be undervalued compared to Netflix's newfound ability to pull in meaningful cash profits. And I started not from next year's $3.5 billion cash-flow projection, but this year's artificially inflated $5 billion. I'm not trying to fabricate sky-high valuations out of thin air here -- just poking and prodding at a modest set of expectations to see what I might get.
Anyone who says they know exactly how fast a company's profits will grow in five years or more is selling you something that probably doesn't work, and many things could push Netflix's free cash flows higher or lower than expected.
But you have to start somewhere, and Netflix has hit the ground running. I can't wait to see what's next.
