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Netflix Just Proved 2 Aspects of the Stock's Bull Thesis

The Motley Fool logo The Motley Fool 10/24/2020 Danny Vena
Netflix Just Proved 2 Aspects of the Stock's Bull Thesis © Provided by The Motley Fool Netflix Just Proved 2 Aspects of the Stock's Bull Thesis

When Netflix (NASDAQ: NFLX) reported its third-quarter results after the market close on Tuesday, the headline numbers were something of a mixed bag. Revenue of $6.44 billion grew roughly 23% year over year, while net income of $790 million climbed about 19%. Customer growth sputtered, adding just 2.2 million new subscribers, slightly below the 2.5 million Netflix had forecast. The tepid customer growth sent investors running for the exits, and the stock slipped about 7% on Wednesday following the report. 

There were two important metrics shortsighted investors largely ignored that, taken together, provide compelling evidence that the investing thesis for Netflix is largely intact, and that the bulls have been right all along.

$100 Dollar bills with face masks on Benjamin Franklin falling from a stormy, cloudy sky. © Getty Images $100 Dollar bills with face masks on Benjamin Franklin falling from a stormy, cloudy sky.

Show me the money!

Free cash flow (FCF) has long been a battleground metric for Netflix bulls and bears. Bears point to the growing red ink that stains Netflix's financials as evidence that the company will likely never succeed. To their point, Netflix's FCF was negative $3.3 billion for 2019. Management argued at the time that it believed last year marked the peak of its FCF deficit, forecasting an improvement to a deficit of $2.5 billion for 2020.  

For their part, bulls have always argued in favor of the virtuous cycle. By spending heavily on content, Netflix would attract new subscribers, using the revenue from those customers to create new content, which in turn would attract more new subscribers. At some point, the cycle would become self-sustaining, especially once Netflix takes its foot off the gas when it comes to creating new programming.

The pandemic has provided a sneak peak of how that could look. Many of Netflix's production facilities were shuttered early this year, which not only tipped FCF into the black, but also provided a preview of what the future could hold. Netflix has now generated three successive quarters of positive FCF.

 

Q1 2020

Q2 2020

Q3 2020

Free cash flow

$162 million

$899 million

$1.145 billion

Data source: Netflix. 

Management is now estimating that FCF for the fourth quarter will be "slightly negative," and expects to generate about $2 billion in FCF during 2020.

This helps illustrate what will happen when Netflix eventually decides to rein in its spending on new content: Positive FCF will become the rule rather than the exception, and the company is on target to become a cash flow machine.

The world is their oyster


Video: Price is right to buy Netflix: advisor (Reuters)

Netflix bulls have long argued that while domestic subscriber additions were slowing, the real growth story was the worldwide streaming market. Over the past several years, the company has worked to jump-start that growth by focusing heavily on local language content and creating stories that would resonate with an increasingly global audience.

The growing contribution by international locales to Netflix's growth story has continued to play out much as bulls have envisioned.

Region

U.S. & Canada

Europe, Middle East, Africa

Latin America

Asia-Pacific

YOY subscriber growth

9%

31%

24%

62%

Data source: Netflix.  YOY = Year-over-year.

As the above chart shows, the Asia-Pacific and the Europe, Middle East, and Africa regions accounted for the bulk of Netflix's subscriber growth and, not surprisingly, had corresponding increases in revenue.

Netflix called out the Asia-Pacific region as the largest contributor to paid member growth, responsible for 46% of subscriber gains during the quarter, driven by double-digit penetration in both South Korea and Japan. The company is working to take the lessons learned in these subscriber hot spots and replicate that success in India and other countries.

This illustrates the importance of Netflix's global growth strategy, but also shows that the bulls' thesis regarding global growth is right on the money.

A buying opportunity?

Since hitting an all-time high back in early September, Netflix shares have slumped 15%, as investors fear the coronavirus-induced growth story has ground to a halt. But given the long-term opportunity and the strength of the bull thesis, investors with a sufficient time horizon (three to five years) should look on this as an opportunity to initiate a position or add to an existing one.

There's a whole big world out there, and the Netflix growth story is far from over.

Danny Vena owns shares of Netflix. The Motley Fool owns shares of and recommends Netflix. The Motley Fool has a disclosure policy.

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