Ravenscroft Group | Ben Byrom
04 May 21

Weekly Update - It's earnings season - we explain why Netflix's earnings announcement caught our eye...

This week's update comes from Ben Byrom, a member of the discretionary investment management team in the Channel Islands.

Subscriber growth miss

In its Q1* earnings announcement (click here to access a copy of its ‘letter to shareholders’), Netflix put on a show that many companies would be extremely pleased with:

  • Revenue +24% year-on-year, in-line with company forecasts

  • Operating profit and margin reaching all-time-highs

  • Paid members reached 208m, +14% year-on-year

  • Average revenue per membership + 6% year-on-year (5% at constant FX rates)

Yet shares slid up to 11% in afterhours trading due to an unexpected miss in paid member subscription growth, which is a key metric that powers Netflix’s growth narrative and subsequent valuation (9.1x sales before the earnings release). This was a rare event, made especially rare by the size of the miss - some 2m subscribers (see highlight in the chart below). The Company blamed the pandemic for pulling forward future subscriptions thereby reducing their forecast for additional net subscribers to a measly 1m - the lowest prediction the Company has posted in the last five years.


Chart 1 Over the last five years, 2021 Q1’s net additions miss was the second biggest, whilst Q2’s 1m net additions prediction will be the lowest. Source: Netflix Letter to Shareholders
*Q1 is calendar quarter

Consolidation

The market has exhibited caution with Netflix shares, following the stellar 2020 Q1 and Q2 subscriber growth beats and shares have traded sideways since mid-July last year in a broad range between $450 - $575 a share – such volatility is par for the course for Netflix investors.

So, what next for share prices?

Of course, there is no telling where prices may go next in the short-term, but historically we can observe the price action around Netflix’s previous miss of this magnitude (in Q2 of 2019) when it missed by some 2.3m subscribers. Back then, shares capitulated ~30% over the following three months, even after the company offered investors a much more optimistic 7m subscriber growth estimate for the following (third) quarter. Were history to repeat or follow a similar path, then such a slip would push prices to areas that have acted as support and resistance in technical terms around the $387 level.


Source: Chart compiled by Ravenscroft on the Trading-view charting platform

Based on the last 12 months sales, the price-to-sales multiple would reach 6.4x, a valuation multiple that has been favourable to investors in the past - last seen in Q3 2019 and Q2 2017 - with an average share price appreciation of ~100% in the 12 months following.


Source: Chart complied by Ravenscroft using data from FactSet

Could it be different this time?

The shareholder letter wasn’t all doom and gloom; far from it. Netflix reminded its investors that it has faced and overcome many challenges and if current financial trends persist then it would reach free cash flow (“FCF”) parity by the end of the year. This would be a major steppingstone in the evolution of the Company towards becoming a highly cash generative business.


“Our ability to evolve from a DVD-by-mail to an internet entertainment business, from a US-only to a global service, and from a licensor of second window content to a producer of original content across so many different categories fuels our confidence and optimism for our next decade of challenges, growth and innovation”.

The promise of FCF parity may well underpin shares this time around; it has been the missing piece to Netflix’s growth narrative in the past and an outcome on which investors have been clearly speculating. Supporting shares further is the resumption of a sustainable buyback programme. With FCF parity around the corner management stated they would maintain debt at current levels, preferring to allocate surplus cash to buying back their stock.

That said, parity is not here yet and Netflix investors will have plenty to focus on with the competition revving up and competing effectively for a share of consumer’s wallets, whilst the need for a constant stream of high quality content pushes costs higher.

All eyes on Disney

Following management’s upward revisions to their 2024 subscriber numbers during an investor day in December 2020, The Walt Disney Company is now considered a streaming force to be feared.

Should we expect a similar miss by Disney too and what would that mean for the sector? This is a difficult question to answer given the timings of product cycles, business model composition and management mindsets. For example, Disney+ was launched only a few years ago, many years after Netflix had established the streaming market creating its first mover advantage and leadership in the process. Without the hurdle of having to create its own market, subscriber growth rates surpassed management’s rather conservative estimates. Conservatism is Disney’s playbook - under promise and over deliver - and whilst numbers were upped quite significantly late last year, it is hard to imagine Disney’s leadership over-inflating estimates just to whet investor appetite for their company’s stock. In addition, Disney doesn’t offer specific quarter-on-quarter subscriber growth rate estimates.

We suspect the market will be interested in streaming progress but Disney’s “somewhere out there in the not too distant future” outlook may be vague enough for the Company to acknowledge steady progress without having to be too specific. What the market will be more focused in on will be the streaming unit’s progress to profitability, as well as management’s outlook for Parks and Resorts; an area of particular concern driven by the Covid-related shutdowns. This part of the business model has suffered severely since Covid, costing the company vast sums of money in fixed cost expenses, which it was unable to reduce in the near term. Visitors need to start coming through the door and the sooner the better. With rumours that prices are rising, as interest shows no sign of abating, it’s more a question of when the cash will start ringing through the tills, and not if...

The great pull forward

Moreover, the pandemic revealed a flaw in Disney’s entertainment model and the market during this timeframe rewarded the more singular approach of Netflix. The reopening of economies is likely to demonstrate a vulnerability to the singular approach, as Netflix will undoubtedly face more competition for its share of consumers’ wallets than it has done historically. The next few quarters will be telling, and we may well see a reversal of several trends we have witnessed whilst under lock-down. For example, will luxury companies still enjoy the wallet share that would have otherwise been allocated to experiences? Will Nike’s gangbuster ecommerce growth (up 60% year-on-year to the end of February 2021) abate now consumers can enter stores or do other things?

It has been our opinion that the global pandemic has pulled forward sales and that certain businesses should be worth more as a result, even if there is an imminent period of consolidation. However, time will tell whether the pull forward some of our holdings have benefitted from will either regress to their pre-pandemic levels, or whether they will maintain their long-term trend growth, but from their newly acquired higher base. Those that can’t, will almost certainly de-rate. Those that can, just may justify their current values. We will share more of our views in the future.

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