Netflix: Q2 Earnings Leave Many Questions, Few Answers

The gulf is significant. First-half results suggest amortized content expense this year will run about $13 billion; per management, cash spending should come in at roughly $17 billion.

And so based on guidance for about $1 billion in free cash flow, NFLX is trading at ~90x FCF. Net earnings, however, should be closer to $5 billion, suggesting a far more reasonable price-to-earnings multiple around 18x.

It’s important to note: this is not just an accounting issue. One key, and still unanswered, question here is for how long Netflix’s content retains real value. If the company needs a hit like Stranger Things every quarter (or so) simply to keep subscriber levels flat, then the economic value of the business leans more toward FCF-derived valuations.

If, on the other hand, the creation of content provides material value in keeping subscribers happy three or five years from now, then cash spent now (or in 2021) is paying off in 2025 and 2027. In that case, earnings are a more accurate representation of the business’s economics.

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We don’t yet know the answer. But commentary after Q2 suggests we might soon. Netflix management said on the Q2 conference call that content spending would plateau in the coming years. That’s a big change: cash content spend will roughly triple between 2015 and 2022.

If Netflix can hold spending in check and still grow subscribers, then this business is too cheap. If, however, the company needs more and more new content simply to keep existing users happy, the next few years should see more subscriber losses — and potentially a sharply lower NFLX stock price.

After Q1 earnings, Netflix said that it was looking at launching an announced a partnership with Microsoft (NASDAQ:MSFT) to deliver that service.

The Q2 call had a bit more color on the effort — but once again, there are more questions than answers. Netflix advertising should arrive early next year — but that’s about all we know. Chief Product Officer Greg Peters offered commentary in corporate-speak that confused more than illuminated:

"…over time, we think there's a tremendous opportunity to leverage that innovation DNA that we have as well as a bunch of sort of enabling characteristics around addressability and measurability and things like that… So there's a bunch of lines of inquiry, lines of innovation that we're going after that sort of support all of that piece, and I think we'll get into that iteratively as we go."

Peters did say elsewhere the initial reaction from potential advertisers was “quite strong,” and it’s possible advertising can really move the needle here. In Disney's (NYSE:DIS) fiscal 2019, its media business generated about $7 billion in advertising revenue worldwide. Netflix has a larger subscriber base, and likely greater viewing time (the 2019 figure was two hours per day on average, per one of its executives at the time).

Ostensibly, Netflix’s advertising revenue over time could clear $10 billion or more. The question, of course, is how much that ad sales would detract from subscription revenue. Presumably some existing users would downgrade. The net impact overall would be positive (or else Netflix would stop doing that), but the boost to earnings might only be measured in a handful of billions at most.

Against a $90-billion market capitalization, that’s not nothing, obviously. And perhaps the confirmation and discussion of the move into advertising explains some of the post-earnings rally.

Still, it seems at the least early to see NFLX stock as a buy simply because ad-supported tiers are on the way next year. As with the rest of the business, no one — not even Netflix management — knows precisely how this initiative will play out.

The success of the advertising business, at least in the near term, rests on another unknowable: what, exactly, the economic landscape looks like next year. The macro environment might hit subscription revenue as well.

Netflix management was asked on the call how they saw demand holding up in a recession. Chief financial officer Spencer Neumann replied that “most forms of entertainment have been fairly resilient to [economic] downturns.”

There’s certainly some truth to that. But the question for Netflix subscription revenue isn’t whether streaming as a whole holds up. It’s whether consumers are willing to pay for three and four different services — and whether Netflix necessarily makes the cut.

Even if it does, a weaker economy may lead to higher adoption of an ad-based tier, which, in turn, would likely hit the company’s revenue and profits next year and going forward. (However, the ad-based product develops, it seems exceptionally unlikely that full monetization will arrive instantly.) Once again, investors are playing a bit of a guessing game.

There simply are a lot of questions here — and a lot of risks. A reasonable investor can see Netflix stock as a steal here, with advertising revenue driving earnings growth, and moderating content spend leading to sharp increases in free cash flow. She can also see the stock as a sell, given still-minimal free cash flow and the potential for further pressure from macroeconomic effects.

Personally, I’d lean toward the bearish side here. Subscriber growth in the most-profitable regions has stalled out: the number of paid memberships in the U.S. and Europe combined is up just 2.5% over the last 12 months. Free cash flow should rise if the ceiling holds on content spend, but that’s a big ‘if’ and, again, we’re still at roughly 90x this year’s FCF.

At the least, patience seems to be advised. It’s going to take time for the answers to so many key questions to unfold. In the meantime, in a still-nervous market, it seems at least likely that a cheaper price might be on offer at some point.

As of this writing, Vince Martin has no positions in any securities mentioned.