Netflix stock has come under pressure as rising interest rates have triggered a “flight to safety” away from risky stocks.
Shares of Los Gatos, California based streaming giant Netflix Inc (NASDAQ:NFLX) are down around 20% from its peak in the last few months. However, most of the company’s shareholders won’t be sweating too much. Netflix stock is still up over 85% this year. And analysts’ continue to remain bullish on the stock. After all, the company has continued to deliver strong revenue and subscribers growth. But the recent correction does point towards the pressure building on Netflix stock. Subscribers number miss in the previous quarter, rising yields and competition has several investors worried, especially given the company’s lofty valuation multiples.
Source: Netflix stock by uniquefinance.org
Netflix stock is primarily driven by subscribers growth. The idea is that, in the long run, the company will be able to spread the production cost over its massive subscribers base at an increasingly efficient rate, resulting in higher operating margins. The company has managed to deliver on the expectations over the past years, driving the stock higher. The subscriber number has kept growing, both at home and abroad, hitting almost 130 million at the end of the previous quarter. As long as the company keeps adding more subscribers every quarter, shareholders don’t have to worry too much. Investors will be paying close attention to this number when the company reports its third-quarter earnings on October 16th, next Tuesday. The management guided for 650,000 new members in the U.S. and 4.35 million new members abroad.
With more and more consumers cutting the cord and joining the streaming world, the subscriber numbers will continue to grow. The video streaming penetration rate is low, even in the advanced economies. The advent of 5G, rising internet and smartphone penetration along with Netflix’s strong content portfolio will be key to the company’s growth strategy. Data cost is declining, mobile screen size is becoming larger and smartphone penetration is growing every month. According to a report by Deloitte, smartphone penetration has reached 80% in most of the developed nations. All these factors will lead to more content consumption. Every new mobile user is a potential customer for Netflix.
Mobile users growth leaves plenty of room for expansion, a market of 1 billion possible subscriptions worldwide. But just expanding market size doesn’t guarantee Netflix’s success. The company has to continue dominating this segment which is seeing strong interest from various companies from the entertainment segment and outside. Disney is planning to launch a subscription service early next year. Facebook and Apple too have plans for producing original content. Rising competition from the likes of Amazon, Hulu and Disney could dent Netflix’s subscriber growth.
Of course, the strong content library will give Netflix a big advantage over its competitor. With the exception of Walt Disney (NYSE:DIS), Netflix’s content compares more favorably with its competitors. In fact, Netflix bagged the maximum number of Emmy nominations, breaking HBO’s amazing 17-year run. Netflix has increased its nominations every year since first debuting original content. And when it comes to millennials, Netflix leaves the competition far behind. In a survey, about 70% millennials said that Netflix has the best content. Netflix’s original content has especially been received very well.
As we have discussed earlier, Original programming is the key to success in this segment. Over 42% of Netflix subscribers cite original content as the reason they pay for their online video subscription. New shows and movies drive gross subscriber additions. So, for Netflix to continue growing rapidly, it needs to churn out better shows than its competitors at a faster rate. And Netflix has been doing that. The streaming giants next year content slate is shaping up to be meaningfully stronger than 2018.
Rising bond yields will keep Netflix stock under pressure.
However, producing original content costs money, tons of them. Netflix’s content budget has been growing rapidly over the past few years and is rivaling those of established production companies. Netflix plans to spend between $7.5 billion and $8 billion on content this year, resulting in about 700 new series’ and 80 original films. But there is a limit to how much Netflix can spend on content. The company has famously been free cash flow negative for years.
The company’s operating cash flow in 2017 was negative $1.7 billion. To meet its cash requirements, the company has been approaching debt markets. The company’s debt is already ballooning. Going by the company’s investment plans, Netflix will continue to need billions of dollars in cash. While Netflix has been able to raise debt at attractive rates till now, the rising bond yields will make company’s job more difficult now onwards.
Also, rising interest rate could have a negative impact on its valuation. Technically, the value of a company is the free cash flows discounted to the present. Higher the discount rate lower the value of the company. The discount rate is nothing but the weighted average cost of capital (i.e debt and equity). Higher interest rate results in both higher cost of debt and higher cost of equity (through higher risk-free rate) which reduces the value of the company. Rising yields will also impact Netflix stock as investor migrate from riskier stock investments to safer bond market investments. The recent correction in Netflix stock has been mainly due to this reason. Rising interest rates could keep Netflix stock under check, despite a strong performance on the subscribers’ addition front.