Walt Disney (DIS 0.25%) is giving investors a better look at its financials, breaking out its sports business from the entertainment business. And that can give media stock investors a much better idea of how profitable entertainment media is for a company versus spending big on sports rights.
One media company that's avoided sports rights so far is Netflix (NFLX -1.18%). While the streaming leader spends heavily on its entertainment content, it's been able to steadily grow profits since its global expansion in 2016. But Disney's new financial reporting shows just how much more room there is for Netflix to grow.
The massive profit potential of Netflix
Netflix's primary measure of profitability is its operating margin.
From 2016 through 2021, Netflix's operating margin grew from 4% to 21%. Over the past two years, it's only managed to maintain that margin profile, with management estimating for this year a 20% operating margin for the full year.
But Netflix CFO Spencer Neumann sees a lot more upside. And Disney's new financial reporting might confirm that outlook.
"We've got a bunch of benchmarks," he said at a Netflix investors' conference last month. "You know them as well as I do, of networks at scale that are well above 20% operating margins. So we think we've got a lot of headroom."
Disney is the definition of "networks at scale." While it once topped 100 million U.S. subscribers for multiple cable networks, it still counted more than 70 million for seven networks as of the end of last year. Linear networks, including ESPN, generated more than $28 billion in 2021 and 2022 for Disney. For reference, Netflix's 77 million U.S. and Canadian subscribers generated about $14.5 billion in revenue over the past four quarters.
Disney previously included the ESPN family of networks in its linear networks reporting. And in 2022, the segment generated a very respectable 30% operating margin.
But sports has been a drag on Disney's operating margin. That shouldn't be a surprise, given the rapidly rising cost of sports rights combined with the proliferation of cord-cutting. Under Disney's new reporting segments, sports generated an operating margin of less than 16% last year.
The entertainment networks, on the other hand, are big moneymakers. Linear networks under the entertainment segment generated an operating margin of more than 40% in 2022. That's double Netflix's operating margin.
That's the massive profit potential of Netflix.
Reaching its potential
If Netflix is going to double its operating margin, it won't be an easy feat.
Disney is a 100-year-old company. It didn't get its media networks business to a 40% operating margin in a few years. And neither will Netflix.
The way Netflix thinks about margin is a balance between future growth and near-term profits. It sets a target operating margin for the year, and since it's a subscription business with relatively predictable revenue, it can spend according to plan in most years -- when there's not a pandemic or multiple industry worker strikes.
As it grows revenue, it creates operating leverage, particularly around content spend. While Netflix's cash content spend has been lumpy because of interruptions over the past few years, its amortized content expense has steadily climbed from $7.5 billion in 2018 to $14 billion in 2022.
Those increases should slow significantly in 2023 and beyond, as the gap between cash spend and amortized spend closes and management slows the increase in cash spending. Indeed, amortized content expenses are up just 3.6% through the first nine months of 2023.
Meanwhile, revenue is reaccelerating. Management has seen success with the rollout of paid sharing and the ad-supported tier. It announced new price changes recently, pushing more subscribers toward its standard plan or its ad tier, both of which generate similar revenue per member at the moment. While advertising doesn't play a significant role in Netflix's revenue at the moment, it could be a key determinant in its future revenue growth.
While operating margin is Netflix's primary metric for profitability, VP of Finance and Investor Relations Spencer Wang was keen to point out that total profit dollars still matter. That's why it's investing in new areas such as gaming or building better ad technology. Both areas have the potential for high margins, too, but will drag down operating margin in the near term.
The path is simple for Netflix. It's building an entertainment network at scale. Disney just showed investors the potential for that business, and Netflix is setting its sites on getting to that same level.
Even after the stock's strong price performance over the past 15 months, shares still trade at an EV/EBITDA multiple well below Netflix's five-year median. And while it's seen a big improvement in its profit margin in that time, there's still a long way for it to go. That could make Netflix a valuable addition to your portfolio at this price.