Netflix stock (NASDAQ:NFLX) has undergone a massive rally over the past year, more than doubling from its 52-week lows of ~$162. However, is it possible that the rally is starting to run out of steam?
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On the one hand, there are several positive catalysts currently supporting Netflix’s bullish case, including lasting subscriber growth, industry-leading profitability metrics, and a promising ad-supported model.
On the other hand, the stock appears significantly overvalued relative to future earnings growth projections. Consequently, I believe that Netflix has limited upside potential from its current stock price levels. Therefore, I am neutral on NFLX.
Netflix’s Bull Case
Netflix’s bullish case can be broken down into three key elements, in my view — continuous subscriber growth, unmatched profitability metrics within the industry, and a promising ad-supported model. Let’s delve deeper into each of those!
Subscriber Growth
Netflix continues to impress with its subscriber growth, expanding its already massive base of over 250 million active paying accounts. To provide context here, Netflix was one of the major beneficiaries of the COVID-19 pandemic. With restrictions persisting globally and consumers pivoting to home entertainment, Netflix managed to sustain robust net subscriber additions during 2020 and 2021.
However, as soon as the COVID-19 tailwind evaporated, Netflix reported its first net subscriber decline, losing about 200,000 paying members in Q1 of 2022. This caused panic among investors, who feared that the company’s winning trajectory would soon dwindle, particularly with the emergence of competitors such as Disney+ (NYSE:DIS) in the market at the time.
Fortunately, this setback turned out to be temporary. Even though Netflix experienced a brief decline in subscriber growth due to the reversal of some COVID-driven memberships, it swiftly bounced back into growth mode. In fact, Netflix has consistently grown its membership count every quarter since then, with its Q4-2022 growth being especially noteworthy, boasting a remarkable sequential hike of 3.4%.
Unmatched Profitability Metrics
With Netflix continuing to drive subscriber growth to this day, the company has mastered unlocking the benefits of scaling economics, resulting in industry-leading profitability metrics. In Fiscal 2022, Netflix posted an operating income of $5.6 billion, a net income of $4.5 billion, and free cash flow of $1.6 billion.
Now compare this with Disney’s service. Even though Disney+ has already grown its membership count to a massive 137.7 million, Disney’s DTC segment posted an operating loss of about $4 billion in Fiscal 2022. In fact, operating losses widened from the previous year’s $1.6 billion.
It’s reasonable to assume that the same holds true for Amazon’s (NASDAQ:AMZN) Prime Video segment, given the company’s substantial investment in streaming. This investment is unlikely to be offset by Prime membership revenues, as Prime offers a multitude of benefits to consumers beyond streaming, and the Prime segment itself was not profitable last year.
I am not even going to touch upon Netflix’s smaller competitors, such as CuriosityStream (NASDAQ:CURI), which are losing money big time.
Promising Ad-Supported Model
Netflix’s recent introduction of an ad-supported model seems like a highly-promising development, one that is expected to continue driving both its top and bottom-line growth. Notably, the company’s lower-priced ad-supported subscription plan was launched in 12 countries just six months after its initial announcement in November.
Until now, Netflix has relied solely on subscription revenues for cash flow. However, with the introduction of its ad-related revenue stream, the company will soon be reporting revenues from two distinct segments in its upcoming earnings reports.
But why do I think that the ad-supported model will be accretive to Netflix’s profitability? Well, for starters, the company’s own management has attested to the fact that this model will bolster revenues and profits. But beyond that, it’s easy to see why.
By embracing the ad-supported approach, Netflix will be able to tap into a previously untapped user base that has been unwilling to pay for content on the platform. This means that the company will generate supplementary revenues from a brand-new audience. The basic ads plan will only display around five minutes of ads per hour, which is hardly enough to bug viewers with program interruptions.
At the same time, advertisers will find Netflix to be a welcoming home since they can leverage user data to deliver top-quality ad content. This allows Netflix to charge premium ad rates, which should translate into a highly-profitable new revenue stream. Importantly, Netflix won’t have to spend any additional funds on creating new shows for this ad-supported model. Instead, they’ll be using content from their existing catalog. This means that the lion’s share of ad-related cash flows will go directly to Netflix’s bottom line.
Is NFLX Stock a Buy, According to Analysts?
Turning to Wall Street, the stock has fetched a Moderate Buy consensus rating based on 17 Buys, 16 Holds, and two Sells assigned in the past three months. At $357.53, the average Netflix stock price target implies just 4.9% upside potential.
The Takeaway — Netflix’s Valuation is Too High
Netflix’s bullish case appears rather strong, with the company featuring a number of factors that are likely to keep propelling its revenues and profits higher. That said, as Wall Street’s estimates suggest, it’s quite likely that most of this upside has been already priced in and that the stock has limited upside following its extended rally from last May’s lows.
In fact, even though consensus estimates point toward notable earnings-per-share growth of 14.8% to about $11.40 for Fiscal 2023, this implies a hefty forward P/E of about 30. In my view, that’s a significantly elevated multiple, given where most of the rest of the Nasdaq (NDX) constituents are trading, especially when taking into account that interest rates remain on the rise.
Therefore, if you have already recorded some significant unrealized gains following the stock’s rally, it could be a smart move to book some profits and de-risk your holdings from a possible P/E compression in the coming quarters.
