Few companies have had such an impact on the media industry as Netflix (NFLX +1.32%). It's a pioneer in subscription video on demand, and its model is now an essential piece of every media company's strategy. The pressure it has put on traditional cable television and theatrical releases has also led to significant industry consolidation over the last decade-plus.
Now, Netflix itself is at the center of a big media merger. The company agreed to acquire most of Warner Bros. Discovery (WBD 0.04%) late last year. However, uncertainty about integrating the two companies and fears of a bidding war between Netflix and Paramount Skydance have led to a sharp sell-off in the shares.
The question for investors is whether the sell-off represents a buying opportunity or if there are good reasons to avoid Netflix stock.
Image source: Netflix.
Netflix's big merger question mark
Netflix's all-cash offer to acquire the streaming and studio assets of Warner Bros. Discovery was already a considerable number, and it may get even bigger. The companies agreed to give Paramount Skydance another opportunity to make its best and final offer by Feb. 23. That could result in Netflix having to increase its offer to finalize the agreement.
Netflix plans to take on $52 billion of debt in addition to Warner Bros. Discovery's existing net debt of $10.7 billion to fund the acquisition. While the debt may be manageable, given that both companies produce strong free cash flow and Netflix continues to increase its free cash flow year over year, that's still a significant sum to put on its balance sheet.
There are significant question marks about Netflix's ability to execute following the merger and ensure it gets good value from the assets it's purchasing. The new company, with its studio and production facilities, will be vastly different from the asset-light Netflix of today. What's more, 80% of HBO subscribers already subscribe to Netflix, so some might wonder how much it can gain from cross-selling Netflix and HBO.
Still, Netflix expects the deal to be accretive to its earnings per share within its second year. It expects $2 billion to $3 billion in cost savings by year three. Importantly, there's notable upside that investors may be discounting. Netflix may be able to reduce subscriber churn and increase engagement across the streaming services with the broader content library and intellectual property rights of the combined company. That could boost earnings per share.
While the ongoing merger talks have created significant uncertainty in the business, Netflix's core operations now appear to be trading at a discount.
NASDAQ: NFLX
Key Data Points
Missing the forest for the trees
Netflix may be an increasingly complex business, but at its core, it follows a simple model that produces strong operating earnings growth over time. Given that most of its revenue comes from monthly subscriptions, management can estimate its annual revenue with reasonable accuracy. That enables it to budget for its most significant operating expense every year: content. With those two factors in place, it can set a target operating margin and usually deliver.
Last year, Netflix produced an operating margin of 29.5%. This year, Netflix is targeting an operating margin of 31.5% on the back of 12%-14% revenue growth. Management has consistently delivered operating margin improvements over time.
Along with year-over-year improvements in operating income, Netflix has shown strong free-cash-flow conversion over the last few years. Free cash flow grew to $9.5 billion last year, and management expects $11 billion this year. That number would be higher if not for a one-time cash deposit of $700 million to Brazilian tax authorities related to an ongoing dispute.
The advertising business presents another growth driver for Netflix (which will integrate nicely with HBO's ad-supported tier). Netflix grew ad revenue 2.5 times to $1.5 billion last year, and it expects that number to double in 2026. While advertising sales aren't as predictable as subscription revenue, upfront sales can provide some clarity. Meanwhile, they enable Netflix to reach a broader audience, monetize that audience at a high rate, and reduce subscriber churn.
The addition of Warner Bros. studio assets will provide some vertical integration for Netflix and add more uncertainty to revenue, as box-office sales are far from guaranteed. But if Netflix continues to follow its strategic playbook of maintaining content investment levels in line with its financial targets, it should deliver more earnings upside even amid more volatile results.
After the sell-off, Netflix now trades for just 25 times forward earnings estimates. That's a valuation investors haven't seen in years, and it reflects the increased uncertainty in the business from the WBD acquisition. But with strong execution on the core business and the potential upside from the acquisition, Netflix stock looks like a great investment opportunity at this price.
