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Netflix Stock: Net Margins Need to Improve

It’s reasonably safe to say that everyone is familiar with Netflix (NFLX).

With over 209 million paid subscribers (and multiple more viewers, including the households in this figure), Netflix has become almost synonymous with streaming services. Having first-mover advantage certainly helped in establishing its dominant position.

However, competition has been heating up lately. Major players in the industry like Disney (DIS), AT&T (T), and Amazon (AMZN), with their respective services of Disney +, HBO Max, and Prime Video, have saturated the industry.

In fact, niche streaming services have started to target very specific target groups to grab the market shares in these underserved markets. Examples of such services include Gaia (GAIA), CuriosityStream (CURI), and FuboTV (FUBO).

Hence, investors may rationally speculate that Netflix’s dominance shall fade, with subscription growth likely to stall moving forward. While such concerns translated to Netflix trading flat for around a year, the stock has recently reached new highs. (See NFLX stock charts on TipRanks)

Accordingly, Netflix’s future remains rather bright. The company should start producing satisfactory free cash flow levels, and eventually return some of this cash through its stock repurchase program.

Hence, I am bullish on the stock. However, the risk which comes with the never-ending need to produce original content is likely to weigh Netflix down.

Solid Growth, but Margins Need to Improve

Netflix’s Q2 results were rather strong, with revenue increasing 19% year-over-year to $7.3 billion. Revenue growth was primarily supported by an 11% rise in average paid streaming memberships, and an 8% increase in average revenue per membership (ARM). Excluding a foreign exchange (FX) impact, ARM rose 4%, to be exact.

As a result, Netflix’s net income also expanded significantly, by 87.9% to $1.35 billion. Despite these numbers, what rattled investors was management’s guidance. The company expects Q3 revenues of $7.48 billion, implying year-over-year growth of just 16.2%.

Is this rather worrying? Does this mean fears of a potential slowdown are finally starting to materialize? Maybe. The truth is, Netflix does not necessarily need to rapidly grow its subscribers at this point. A significant improvement in margins is all that is needed, in the end, to justify its admittedly pricey forward P/E of 45.9.

The company knows this, and efforts to improve margins in order to sustain the continuously higher original content production expenses have indeed been achieved as Netflix scales.

The annual operating margin has been growing every year sequentially for quite some time now. From just 4.3% in 2016, it is expected to reach 20% at the end of FY2021. Still, in the last four quarters, Netflix has generated $1.84 billion in operating cash flows. Of these, $449 million has been allocated in new content, and $500 million to repay debt.

Hence, the bottom line needs to meaningfully expand if shareholders are to actually see any cash returned anytime soon.

Wall Street’s Take

Turning to Wall Street, Netflix has a Moderate Buy consensus rating, based on 23 Buys, seven Holds, and three Sells assigned in the past three months. At $617.93, the average NFLX price target implies 4.9% upside.

Bottom Line

Netflix has established a household name-level brand value, which should be leveraged long-term through potential acquisitions of the new, smaller players mentioned earlier, as well as pricing hikes.

That being said, at its current valuation, management has still a lot to prove in terms of a much-needed margins expansion.

Netflix’s consensus rating quite accurately reflects this, with little to no short-term upside left at the stock’s current levels.

Disclosure: At the time of publication, Nikolaos Sismanis did not have a position in any of the securities mentioned in this article.

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