To The Moon

Netflix's earnings report was released on 19 July 2022 and it saw a strong post-market rally as per below. However, is Netflix still a good investment with the latest earnings report?

Netflix 1D chart as of 20 July 2022

At the end of the trading hours, Netflix ended at close 04:00PM EDT with 201.63+10.71 (+5.61%) and 217.46 +15.83 (+7.85%) after hours: 07:59PM EDT

This remains an interesting rally as I break down the financials and the earnings report below. This was extracted from their shareholder letter:

Q2 was better-than-expected on membership growth, and foreign exchange was worse-than-expected (stronger US dollar), resulting in 9% revenue growth (13% constant currency).

I find the above statement to be misleading as per the table below:

Netflix Q2/2022 summary results and forecast for Q3/2022

Q2 results & Q3 forecast

If we do a YoY comparison, it is better in most aspects of Revenue, Y/Y % growth, and Net income. What is of concern is that Q2/2022 Free Cash Flow (FCF) is only $13 million compared to the previous Q1/2022 of $802 million though their net cash generated by operating activities amounted to $103 million. This implies that about $90 million was invested into CAPEX.

However, if we compare Q2/2022 with Q1/2022, we will notice that only revenue is better for Q2/2022. For items of Y/Y growth %, operating margin, net income and diluted EPS, Q2/2022 figures were actually worse than Q1/2022.

If we add the Q3/2022 forecast, we will see a continuing downtrend that is worrying against Q2 figures:

• Revenue drops from $7,970M (Q2) to $7,838M (Q3). This is a 1.6% drop in revenue.
• Operating income drops from $1,578M (Q2) to $1,255M (Q3)
• Operating margin drops from $19.8% (Q2) to 16.0% (Q3)
• Net income drops from $1,441M (Q2) to 961 (Q3). This is a drop of 33% of net income expected for the next quarter. This can be something of a concern if the business start to make a lesser profit (net income) over the coming quarters.
• For the Q3 forecast, when we compare a 1.6% drop in revenue against a drop of 33% in net income. This implies that Q3 total expenses are increasing faster than the rate of revenue loss. This is a red flag and something that Netflix needs to look into better manage its costs.

We need to note the following:

We’ve adjusted our cost structure for our current rate of revenue growth. This resulted in approximately $70 million of severance costs and an $80m non-cash impairment of certain real estate leases primarily related to rightsizing our office footprint. Excluding these items totaling $150 million, and the F/X impact of the stronger US dollar since our April report, operating profit and operating margin were slightly ahead of our guidance forecast.

For rightsizing their global offices, Netflix has spent about $150 million in severance and non-cash impairment of real estate leases. While this is a one-time expense, it is not a small amount involved.

The US dollar continues to strengthen meaningfully against most currencies at a historic pace, with the Euro recently falling below the US dollar for the first time in two decades, a significant headwind for all multinational US companies.

The strong USD has led to F/X gains but will pose as a headwind as their services will become more expensive.

Despite the loss of 1 million in paid subscriptions, it is left to be seen if they can achieve a net gain of 1 million subscriptions from Q3. They have also reported a $5 billion of Euro bonds that were used as a hedge against the Euro - which they have reported a gain of Forex $467million accordingly. This is a good move.

Reasons for challenging times

Netflix has cited slowing revenue growth due to an array of reasons including connected TV adoption, account sharing, competition, sluggish economic growth and the Ukraine war. However, some of these reasons such as account sharing and competition have always existed. I do think that the macro market (sluggishness) and competition have more impact on their slowing revenue growth.

They have gone on to list shows with record viewership. For example, Stranger Things Season 4 generated 1.3 billion hours of viewership. This is a record that led to a more recent viewership of the previous seasons. This needs to lead to an increase in subscription revenue or more interest in Netflix. Without which, it is just another record during a quarter where Netflix lost a million paid subscribers (in Q2).

Netflix also seeks to be the leader in non-English streaming content as they continue to produce non-English programs to attract an international audience. They have a few shows that were popular and let us see if this can translate to more subscriptions in the coming quarters.

Having said so, Netflix reached an all-time high in US TV viewership as per the extract below:

as Nielsen will announce on Thursday, our share of US TV viewing reached an all-time high of 7.7% in June (vs. 6.6% in June 2021), demonstrating our ability to grow our engagement share as we continue to improve our service.

Viewership (in terms of billions of minutes) from Nielsen

This is an achievement and hopefully, one that leads to more paid subscriptions. We should also note that Netflix is commanding more airtime than the big 4 news agencies of CBS, NBC, ABC and Fox. Should this trend continue, Netflix getting into news may be an option.

Netflix Gaming

Netflix has offered a total of 24 games, targeting a broad audience, spanning genres and categories. They have also acquired a few game studios as they build up their pipeline of new games. This is a good effort to draw more into Netflix's content offering. However, the gaming sector has many proven players. There is always the potential for them to be a gaming force but one that will require investments and time. Adding the overheads of gaming on top of the current content production, we can expect more "expenses" and lesser "profits" till this reaches critical mass. This is one area where we should monitor as Netflix is not the "go-to" benchmark coming to gaming.

Netflix Advertising and partnership with Microsoft

Netflix has announced a lower-priced advertising-supported offering while their existing plans remain ad-free. With Microsoft (partner in technology and advertisements), Netflix looks to help expand Microsoft's multi-billion advertising business into premium television video. This can be a potential game changer and hopefully, the books in the coming quarters will back this claim.

Cashflow and Capital structure

The below is extracted from the earnings report:

Cash declined $190m sequentially, primarily due to our Next Games acquisition ($69m) and the F/X impact on cash ($145m). As we’ve discussed previously, we are now self-funding. For the full year 2022, we expect FCF to be approximately +$1 billion, plus or minus a few hundred million dollars (assuming no material further movements in F/X).

We’re now more than a decade into transforming our service from licensed second run content to mostly Netflix originals - including more than five years into building out our internal studio to produce the majority of our original titles (60% of our net content assets on our balance sheet are Netflix-produced). We’re now through the most cash-intensive part of that transition. As a result, our cash content spend-to-content amortization expense ratio peaked at 1.6x (along with peak negative FCF of -$3.3B in 2019) and is expected to be about 1.2-1.3x in 2022 and to decline going forward, based on our current plans, which assume no material expansion into new content categories in ‘23.

Having invested in their internal studio, Netflix advised that they have gone through the most cash-intensive part of their internal production. Thus, we can expect lesser CAPEX to be invested in their studio works.

Cash content spend-to-content amortization ratio

This led to their claim that their cash content spend-to-content amortization ratio to decline from an expected 1.3x (in 2022) into the coming years. This is based on the assumption that there is no material expansion into new content categories in 2023. However, this can also be read as no expansion as of now. But there is room for more investment if they choose to venture into new content categories.

Regional Breakdown

Regional performances in recent quarters

From the table above, we note the following (as compared to Q1/2022):

• UCAN (US & Canada) sees a drop of 1.3 million in paid subscriptions though the average revenue per membership has improved from $14.91 to $15.95. This led to an increase in revenue from $3,350M to $3,538M.
• EMEA saw a drop in both revenue and paid memberships. Revenue fell from $2,562 to $2,457 and paid membership fell 0.76 million.
• LATAM saw a slight increase in revenue from $999M to $1,030M and an increase in paid membership by 0.01 million (10,000 new members).
• APAC saw a revenue drop from $917M to $908Mbutpaid membership increased from 33.72M to 34.80M, an increase of 1.08M in paid membership

The growth in APAC is important as this continent has the biggest population compared to others. Despite the growth in LATAM and APAC in paid membership, the loss of paid membership in both US/Canada and EMEA led to the net loss of over 1 million paid members.

This is an evolving situation as APAC posted strong growth of 23% YoY. For Netflix to continue its growth, APAC will be an important battlefield. Thus, production in local languages will be vital for them to establish their foothold in APAC.

Consolidated statement of operations

consolidated statement

For this, let us use the 6 months ended as reference instead of the quarterly ones. Here are some observations:

• Revenue has grown from $14,505M (2021) to $15,837 (2022) for first 6 months, an increase by 9.1%.
• The cost of revenue has increased from $7,886M (2021) to $8,975 (2022) for the first 6 months, an increase of 13.8%.
• Marketing expenses remained about the same - a small increase from $1,116M (2021) to $1,130M (2022)
• Technology and development have increased from $1,062M (2021) to $1,374M (2022), an increase of 29.3%
• General and Administrative expenses increased from $632M (2021) to $807M (2022), an increase of 27.6%
• Thus, all expenses (except marketing) have increased at a much higher rate than the growth of revenue at 9.1%. This is not good and spells more decline in profits if left unmanaged.
• Thus, it is not surprising that the net income saw a drop from $3,059M (2021) to $3,038 (2022) for the first 6 months, a drop of 0.6%.

Consolidated Balance Sheet

Consolidated Balance Sheet (31 Dec 2021 & 30 Jun 2022)

Few observations from the balance sheet (comparing 31 Dec 2021 & 30 Jun 2022):

• Though there is a drop in total Current assets (CA) from $8,069M to $7,840M, but there is also a drop in total current liabilities (CL) from $8,488M to $7,500M. It is good that the total CA is more than the total CL - sufficient assets to manage the current liabilities
• Comparing net debt (total assets less total liabilities), Netflix is currently at a much better position of $19,076M compared to the previous amount of $15,849M. A good improvement of over $3 billion.
• There is also a strong growth of over $3 billion in retained earnings compared to 31 Dec 2021. This is a growth of over 25%.  Retained earnings are a firm's cumulative net earnings or profit after accounting for dividends. They're also referred to as the earnings surplus.

Cashflow

Cashflow of Netflix as of Q2/2022

Observations (6 months period comparison between 2021 and 2022):

• some concerns about the lesser "cash, cash equivalent and restricted cash" at the end of the period from $7,804M to $5,844M
• Stock-based compensation has increased from $208M to $269M. This can be better managed if we face lesser profits in the coming quarters.
• Dilution of stock ownership as more stocks were issued
• Good to see repayment of debt of $700M
• There is a concern of $102M net cash (operating activities) compared to the previous quarter of $922M.
• $193M was spent on the acquisition of new businesses (gaming as mentioned earlier).

In Conclusion

Netflix has shown improvements in a better balance sheet and improved retained earnings. But there are also considerations pertaining to the low FCF, loss of paid membership, stock ownership dilution and the new gaming offering. The partnership with Microsoft in technology and advertisement needs to demonstrate success with more profitability. Q3 forecast points to a decline in total revenue, and net income due to an increase in expenses despite the claim of an additional 1 million paid members (in Q3). Though the US, Canada and EMA are losing paid membership, we are seeing growth in both APAC and LATAM. APAC has a much bigger population to work on and thus, can be an important market for their growth. In lieu of declining profits, I would prefer to be a Netflix customer (not an investor) for now. If they can demonstrate more profitability (not just revenue) and better returns with gaming and Microsoft in the coming quarters, I would consider investing in the business.

@TigerStars