Should You 'Buy the Dip' in Netflix?

Streaming giant Netflix (NFLX) reported its Q3 earnings results on October 20. The company reported revenue of $6.44 billion in the quarter with adjusted earnings per share of $1.74.

Wall Street forecast Q3 earnings of $2.13 with revenue of $6.38 billion for Netflix. We can see that Netflix surpassed analyst revenue estimates but fell short of earnings in its most recent quarter which dragged the stock lower by 10% in the last week.

Let’s take a look at the key metrics that Netflix reported in the September quarter to gauge if the stock remains a top buy for your portfolio.

Netflix has 195 million paid subscribers

In the third quarter, Netflix added 2.2 million paid net subscribers taking its total count to 195 million. In the first nine months of the year, Netflix added 28.1 million subscribers which is already higher than total subscriber additions of 27.8 million in 2019.

The COVID-19 pandemic has acted as a tailwind for streaming companies including Netflix. In the first two quarters of 2020, the company added close to 26 million subscribers as people were confined to their homes, and entertainment options were limited. While the company warned investors about a deceleration in subscriber additions in the subsequent quarters, it might add another 6 million subscribers in Q4.

In its investor letter, Netflix claimed, “Our content successes highlight our ability to tap into our global audience of nearly 200m members and underscore the notion that content is discovered on Netflix.”

The company’s focus on creating original content has been one of the key drivers of subscriber growth in the last decade. Netflix caters to a wide range of users and has invested heavily in developing content. In 2019, Netflix spent $15 billion to buy, produce, and license content, up from its figure of $12 billion in 2018.

Due to the pandemic, these costs may move lower in 2020 but may surge again in 2021 due to a backlog in production. Netflix is also optimistic about second-run programming shows such as Schitt’s Creek, Lucifer, and Cobra Kai that are gaining in popularity with members.

Cobra Kai originally debuted on YouTube’s subscription service in May 2018 and launched on Netflix in August 2020. Now the third season of this series will be exclusive to Netflix and will premier in January next year.

International growth will drive sales

The surge in net subscribers meant Netflix sales were up 22.7% year-over-year in Q3 of 2020. The company expects sales to grow by 20% in Q4 as well to $6.57 billion. Netflix said the Asia Pacific region was the largest contributor to its paid membership growth and accounted for 46% of Q3 global paid net additions in the September quarter.

Its subscriber base in this region was up 62% in the last year and stands at 23.5 million at the end of Q3. Further, revenue from the APAC region soared 66% year-over-year in Q3 as Netflix achieved double-digit penetration of broadband homes in Japan and South Korea. 

India will be one of the key markets for Netflix in the upcoming decade as the country has a population of 1.3 billion. Comparatively, the number of paid subscribers in the country is still less than 4 million.

The international markets in APAC are high growth ones and Netflix is looking to replicate its success in India and other countries.

Positive cash flow

Netflix’s free cash flow which is calculated as operating capital flow less capital expenditures have been negative for several years. A negative cash flow figure indicates the company is unable to generate cash to support its business and needs to raise debt to keep running operations.

In the case of Netflix, content creators get paid upfront. However, these expenses are amortized over time by the company. This difference in the timing of payment is the reason why Netflix reports positive earnings but has negative cash flows.

Netflix ended Q3 with a debt balance of $16 billion which will be used to fund original content over the upcoming decade. However, due to the COVID-19 pandemic, the company reported free cash flow of $2.2 billion in the first three quarters of 2020.

As content production screeched to a halt, the company managed to report a free cash flow and did not raise additional debt. In 2021, Netflix has forecast free cash flow between negative $1 billion and break-even.

Netflix has recently increased its subscription prices in Australia and Canada. If it still experiences encouraging growth, the same strategy can be used to increase prices in other markets including the U.S. This coupled with increasing operating margin may help Netflix report a positive free cash flow consistently by 2025.

What next for Shares of Netflix?

Netflix stock should be on the radar of most investors given its multiple growth drivers that will positively impact revenue and earnings in the long-term. NFLX stock is valued at a market cap of $215 billion indicating a forward price to earnings multiple of 77x and a price to sales multiple of 9.8x, which is not too expensive considering its growth rates.

Analysts expect Netflix to grow sales by 24% in 2020 and by 18% in 2021. Comparatively, its earnings are forecast to rise at an annual rate of 41% in the next five years.

In case the second wave of coronavirus infections result in another round of lockdowns, you can expect Netflix’s subscriber base to surge higher by the end of 2020.

NFLX stock has returned 72% in the last year, 360% in the last five years, and a staggering 1,840% in the last 10 years. Analysts tracking Netflix stock have a 12-month average target price of $545 which indicates an upside potential of 12% from its current trading price.

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NFLX shares were trading at $482.28 per share on Thursday morning, down $3.96 (-0.81%). Year-to-date, NFLX has gained 49.05%, versus a 3.85% rise in the benchmark S&P 500 index during the same period.

Aditya Raghunath is a financial journalist who writes about business, public equities, and personal finance. His work has been published on several digital platforms in the U.S. and Canada, including The Motley Fool, Finscreener, and Market Realist.

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