Earnings Update: The End of The Line for This Market Leader?

October 21, 2022

Tis the season!

I’m referring, of course, to the season when investors sit on the edge of their seats and await with bated breath the earnings reports of their favorite companies.

Given that little has changed on the inflation–Fed–green energy fronts, I thought we could take a look at a couple big names’ earnings reports and see how certain market leaders are weathering the current economic squeeze.

But before we dive into third quarter results, I want to share a quick truth about business growth…

When it comes to revenue and earnings, there are three, and only three, fundamental ways for a company to grow its business:

  1. Get more new customers to buy what they’re selling…
  2. Get their current customers to buy/spend more each time they make a purchase or… 
  3. Get their current customers to buy more often…

That’s it. It’s really very simple. (Keep it in mind. I’ll be coming back to it later.)

So with this bit of “Earnings 101” in mind, let’s take a look at one of this past week’s highlights.

This week’s company is the barometer of all video streaming services. A growth stock with a $120-plus billion market cap that has been the leader in the SVOD industry for years.  And, like most growth stocks, they’ve lately been taking it on the chin…

A Tough Year for the King of Streams

The one-time king of streaming services, Netflix (NFLX), has been taking a beating for the last 12 months. High to low, the company’s stock had collapsed 77% over the course of 2022. 

While it did get a minor boost from the pandemic, Netflix never became overvalued like so many of the work-from-home “COVID darlings” I’ve written about before. Still, like all growth stocks at the time, the boom it had been enjoying came to an end last year.

This January, Netflix’s earnings report for the fourth quarter of 2022 began to show some cracks in the company’s armor. The company actually beat estimates where earnings went and matched the street’s best guesses on revenue. They even beat estimates where net new subscribers numbers went. 

BUT (and there’s always a but…)

Its number of new subscribers was down from Q4 2020. Not only that, the company announced it was only expecting to add 2.5 million new subs in the first quarter of 2022 (way below the 3.98 million they added the year before, not to mention the 6.9 million the street was estimating). The market displayed its displeasure…

Netflix (NFLX) Q4 2021 Earnings

Source: Barchart.com

Then in the first quarter of this year, things got even uglier…

While still beating analysts’ earnings estimates and roughly matching revenue estimates, their subscriber number was a disaster. Projecting to add (a disappointingly low) 2.5 million new paying customers, they actually LOST 200,000 subscribers. And they projected to lose another 2 million in the second quarter.

Once again, the market took the stock to the woodshed…

Netflix (NFLX) Q1 2022 Earnings

Source: Barchart.com

By the time earnings season for the second quarter rolled around, the market was on edge that their report might actually be an answer to the typically rhetorical question “how much worse can it get?” Their earnings beat estimates and revenue was off marginally but their subscriber numbers showed a loss of only 970,000. 

The number of lost subscribers was the biggest in the company’s history. But compared to the market’s expectation of 2 million, it was a relief. The market settled into a sideways to slightly higher range.

Netflix (NFLX) Q2 2022 Earnings

Source: Barchart.com

A Make or Break on Q3 Numbers

With that in the rearview mirror, all eyes this week were on the company’s third quarter report.

And finally the company reported some good news… 

The streaming company posted third-quarter revenue of $7.93 billion and earnings of $3.10 a share, ahead of the company’s forecast of $7.84 billion and $2.14 a share. 

But more importantly than that…

The company added 2.41 million net new subscribers in the quarter, beating its own forecast of 1 million additions. Netflix said it expects to add another 4.5 million subscribers in the December quarter.

The relief could be heard throughout the boardroom…

“Thank God we’re done with shrinking quarters,” CEO Reed Hastings said on the company’s earnings conference call Tuesday afternoon.

And in after-hours trading, the market agreed…

Source: Google Finance

Has Netflix Finally Righted the Ship?

Earnings are typically viewed as a measure of a company’s overall health and growth potential. And they are, but you have to keep a couple things in mind. 

The first is that earnings reports aren’t measured in hard numbers. They’re measured in expectations — how a company performs relative to what the market is anticipating. 

The other thing to keep in mind is that good or bad news is not necessarily measured only in dollars.

Now think back to what I mentioned at the beginning of this article — the three ways a company can grow their business. Let’s go beyond the numbers and see what Netflix is doing in these areas to grow its business going forward.

One means of growing a business is by getting a customer to buy more often. But a subscription-based business doesn’t lend itself to the “buy more often” option. So there’s not much they can do here.

On the other hand, getting customers to buy/spend more per transaction is possible. And Netflix has implemented some changes where this goes.

A few months back they raised their subscription prices a notch with basic service rising to $9.99 a month all the way to the premium plan going up to $19.99 a month. Of course there’s a limit to how high they can raise prices without potentially  driving more subscribers away. (Another option they might consider is to encourage their basic customers to move up the ladder to a higher service tier.)

Another tack they’re taking is to eliminate password sharing. Early on, when they were the only dog in the hunt, the company didn’t care about how many family or friends you shared your paid account with. That’s stopping next year too. 

Now subscribers will be able to pay an added fee to share their account with those in their circles.

These growth strategies have the potential to boost the company’s bottom line. But they both pale when compared to the one thing that makes a subscriber service a subscriber service…

Getting More Subscribers

For years, Netflix has been the barometer for the subscription video on demand (SVOD) industry. They were the original market leader that all the competition — HBO Max, Disney+, Apple TV, Hulu, Prime Video and on and on — was chasing. 

But now the industry has begun to mature a bit. 

Today, they still lead the pack with over 220 million subscribers worldwide. The problem is the pack is a lot more crowded these days. Today viewers have more and more content to choose from. They’re finding services they like, and picking winners and losers in the industry. While the industry is expected to keep growing in the coming years, getting new subs is likely going to become more challenging given the growing competition.

In response to this new customer battle, Netflix has tried to pull a couple rabbits out of their hat… 

To attract folks who weren’t interested in higher monthly fees, they’ve announced a new ad-based version of their service beginning next month for only $6.99. (A policy the company had been steadfastly against in its early days.)

There has also been back and forth about creating more customers (and revenue) by getting more exposure for their exclusive content. 

To that end, there have been talks about pushing more of their content into theaters for longer runs. This idea was shot down by those in the C-suite who argued that offering their exclusive content across other outlets would diminish their subscription value. 

If they weren’t willing to put more value into theaters, maybe they could bring more theater value to their subs.   

Netflix Co-CEO Ted Sarandos suggested the higher ups in production meet with their counterparts at Sony Pictures (with whom they have a content partnership) to see whether they would agree to let Netflix stream Sony’s movies four to six weeks after their release (rather than their agreed upon six to eight month window).

Their request was shot down.

When Netflix executives met with Sony in June to broach the possibility of a shorter window, they were told that Sony makes too much money in the months following a theatrical run selling DVDs, digital downloads and on-demand movie rentals to consider letting Netflix stream their movies at the same time, according to people familiar with the talks.

So much for that.

So What Is the Future for Netflix?

When you think about the future of a growth stock, you have to focus on what makes a company a growth stock.  

For instance, if you’re a mining company, your growth stock status would depend on how quickly you’re expanding your minable holdings. Or if you’re a technology company, your status would depend on how quickly and effectively you can deliver innovation to the market. (Back in the 90s, Intel was the growth leader in tech, delivering processors to everyone in the market… until, that is, AMD became a legitimate competitor.) 

But if you’re a SUBSCRIPTION video on demand company, your growth status pretty much hangs on how many new subscribers you can bring in every quarter. Today there’s expectation for continued growth in the industry. But the battle for subscribers is getting more and more intense. 

And when the key element of a company’s growth stock status starts to fade or drop off, that company’s growth stock status follows.

Netflix may be all too aware of this…

In one surprise development, Netflix said that starting next quarter, the company would no longer give guidance on paid memberships—the metric that has been most important to investors in recent quarters. The company will still report quarterly subscriber data, just not forward-looking guidance on the metric.

If they can no longer put up outsized growth (subscriber) numbers, it may be signaling the end of their growth stock status.

Which isn’t necessarily a bad thing.

It eventually happens to all companies. 

They’ll stay a heavyweight in their industry maintaining a large chunk of market share. They’ll put up solid (but not spectacular) growth numbers year over year. 

At current price levels, their valuation is actually quite reasonable.  

The big difference is that investor expectations will have to change. 

If this is the end of their growth stock run, investors shouldn’t expect to see the $700 level again anytime soon (if ever). 

On the other hand, if this does prove to be their fate, it’ll be time to declare a dividend!

Make the trend your friend,

Bob Byrne
Editor, Streetlight Confidential