As a last-ditch effort, some companies change their business models significantly to create a new growth wave. Netflix (NFLX -1.19%) recently tried this, and the results left a lot to be desired. In 2023, Netflix enacted two changes that challenged its long-term business model: An advertising tier and a password-sharing crackdown.
After investors got a glimpse of what the new Netflix looked like during its second-quarter earnings results, the changes didn't seem to have the effect the company was looking for. As a result, many investors are likely questioning if it is time to let Netflix shares go at this level. So let's look at how Netflix did and see if it's worth holding on to.
Netflix's new initiatives aren't having the intended effect
Netflix's revenue growth has been disappointing over the past year. It hasn't grown revenues by 10% or more in any of the four latest quarters, and Q2's 2.7% growth kept that shoddy streak alive. While management gave guidance indicating the business will improve in the third quarter (it guided for a 7.5% revenue increase), it's still not enough to push Netflix into market-beating growth territory.
NFLX Revenue (Quarterly YoY Growth) data by YCharts
This isn't very pleasant, as the radical password-sharing crackdown and ad tier rollout moves should have had a more significant effect. Still, management cautioned investors against jumping to conclusions too soon, as it believes the second half of 2023 will be more representative of its revamped business model going forward. This plea for patience, while reasonable, may meet skepticism from some investors as these initiatives have already been in effect for several quarters without the expected outcomes.
On the positive side, Netflix's operating margin came in strong for Q2 at 22%. That's critical because Netflix is transitioning from a growth company into a more established one where earnings are more important.
From that standpoint, Netflix expects to post a full-year operating margin between 18% and 20% (the fourth quarter is historically a low point for this company's operating margins). This will likely translate to a mid-teens profit margin at the end of the year.
However, with that profitability and growth level, Netflix's stock looks highly overvalued.
Netflix trades at a high premium
Should Netflix grow at the 7.5% rate in the third quarter and Q4, that would give it full-year revenue of $33.3 billion. With a 15% profit margin, that would generate essentially $5 billion in profits. Netflix's $192 billion market cap prices the stock at 38 times full-year earnings. Compared to the market's 20 times forward price-to-earnings (P/E) ratio, Netflix has a significant premium compared to the broader market.
So, investors must ask themselves: "Is a company growing at less than market pace worth nearly double the market?" To me, the answer is a resounding "no."
Netflix would essentially have to double its profits to return to an average price-to-earnings valuation. Even if Netflix grows at a market-average 10% pace (which it hasn't done for over a year), that would take about seven years to accomplish.
There are many ways to double revenue, including signing up new subscribers and increasing prices. Still, with Netflix bending over backward to create new subscribers (by cracking down on password sharing) and already having one of the highest-priced streaming services available, there's not much room to grow.
As a result, I think investors are best served by moving on from Netflix's stock, especially after its 45% rise this year. While I may be wrong, I don't foresee a scenario where Netflix becomes a market-besting stock because of its high valuation and low growth. There are much more attractive stocks in the market currently, and I think capital invested in Netflix would be better served by deploying it to other areas.
