Market Commentary: Are Only Fools Buying Netflix?

Netflix reported earnings recently and the share price plunged $40 on the day, down almost 8.5%. To anybody who could read the tea leaves, the reaction came as no surprise. But how do you read the tea leaves? Or in other words, what was the giveaway in the financials that led to investors realizing the risk to reward ratio was poor, and could hurt the share price?

Key Points

• If massive marketing investment barely moves the top line needle, investors should investigate about the cause.
• Free cash flow yield can appear attractive, but when stock-based compensation is considered, it can plummet.
• Growth forecasts that don’t change when major fundamentals change, such as Hollywood strikes, are naive.

Netflix Growth Cloaks A Secret Danger

To begin, the revenue growth reported by Netflix was 2.5%. The amateur will move swiftly along at this point. Not much to look at there, but hey growth is growth, right?

Not so fast.

In the first half the year, Netflix spent about $1.2 billion on marketing. A billion dollars of spend to fuel the top line fire led to just 2.5% top line growth. That’s not particularly impressive. In fact, its downright concerning to have to spend $1 billion and barely move the growth needle.

What astute investors could see was the forest from the trees when it came to valuation, which sits at 42x forecast FY 2023 earnings per share. You need to know your comps to know that 42x earnings is a lot.

Indeed, it’s so elevated that the only other major technology stock with a higher earnings multiple is Nvidia. And to worsen matters, Netflix has the lowest growth of the bunch.

It Gets Worse

Another concern for Netflix shareholders is the forecasted free cash flow that sits at $5 billion. That’s a big number but when you factor in stock based compensation, the free cash flow yield is just 2.3%. And that number has the potential to be torpedoed by production halts in Hollywood.

When we examined year-over-year earnings growth we saw similarly concerning numbers. Net income was $1.441 billion in Q2 2022 and $1.488 in Q2 2023. No change in earnings. No growth in earnings? That’s the type of plateau that earns the dagger in the back from Wall Street, which happily delivered by chopping the stock to the tune of almost 10% on the day post-earnings.

The more analysts dive in the more concerns we think they will have. Free cash flow dropping from $2.1 billion in Q1 2023 to $1.339 billion in Q2 2023 is the stuff of investor nightmares.

Indeed we’ll be surprised if management can deliver on the forecasted 7.5% revenue growth figure after just 2.5% this quarter, particularly with Hollywood strikes grinding production of new content to a screeching halt.

Wrap-Up

The bottom line is when buying a stock with an elevated price-to-earnings multiple, the top line revenues must move dramatically to justify massive marketing spend. Absent that, expect the stock is already priced to perfection and will suffer at the first reported mishap as Netflix did in its most recent earnings report.