Will Netflix's Momentum Continue?

Summary

• Analysis of Netflix.
• Buy, hold or sell?
• analysis made as of 01/12/2020: priced at 497.

Executive summary:

Netflix gained over 10 million subscribers in the second quarter of 2020 due to the pandemic. The streaming giant's stock is currently valued as the second most expensive stock among FAANG stocks based on all traditional valuation models. Considering the recent changing macroscopic environment, prospects of Covid-19 vaccines, Netflix’s recent development and corresponding impacts on the firm's fundamentals, I recommend buying shares in Netflix in DEC 2020 (short-term trading).

Persistent impacts of the pandemic: Pfizer Inc’s experimental COVID-19 vaccine is more than 90% effective, suggesting sooner recovery of the global economy and earlier shifts to more off-line activities. This announcement caused a substantial drop in prices for technological stocks on 9/11/2020. I believe that impacts of the pandemic are longer than their belief implied from the market reaction. In other words, investors might overreact and excessively sell technological stocks, more specifically, Netflix. Pifzer’s vaccine is in phase 3 clinical trial which encompasses effectiveness and safety tests. Although its vaccine passes the effectiveness test, there is still some chance of failing the safety test (around 15% (Wong et al. 2019)). Additionally, estimated 200 million doses of COVID-19 vaccines will become available in 2021, being far from a level needed to reach global herd immunity (Gavi, 2020), There are still a bundle of technical issues worth considering, such as COVID-19 vaccines needed to be stored at -70 degrees Celsius, affordability, time needed to distribute vaccines and people’s willingness to get vaccinated. The University of Hong Kong’s professor Yuen Kwok-yung added unknown consequences of vaccinating the unprecedented and enormous amount of people. Last but not least, some shifts in behaviours during the pandemic become habits due to the persistency of the pandemic (almost 8 months since the outbreak in March). For example, people got used to watching movies and TV shows through Netflix. These shifts are less likely to be reversed by COVID-19 vaccines.

Comparative advantages of Netflix: Short-sellers of Netflix have an inclination to believe that more severe competition in the streaming service industry drives down Netflix’s market share and profitability. Disney+, Amazon Prime Video and Hulu are seen to pose threats against Netflix’s business in the US. Netflix’s shareholder letter shows that the US market only accounts for 30% of its total customers, while non-US markets such as EMEA, Canada and Asia Pacific experience customer growth of at least 10% in Q2 2020. Compared to 19 countries covered by Amazon Prime Video, Netflix is available in more than 190 countries. Netflix also has more original films and content than Disney+. However, the competitive environment is dynamic. Disney has been recently conducting reorganization for exploiting streaming entertainment opportunities, while YouTube and TikTok continuously compete for consumer’s attention and screen time usage. If Netflix can effectively perform its globalization strategies and improve its content by continuously investing in the production of Netflix Originals, it still can be everyone’s first choice for online entertainment.

Better-than-expected future financial performance: Q3 2020 financial performance of Netflix was released on 20^th of Oct. Several key indicators were summarized as follows: EPS 1.74 USD versus EPS forecast 2.14 (Refinitiv), Revenue 6.44 billion USD versus 6.38 Revenue forecast billion (Refinitiv), global streaming paid membership 2.2 million versus 3.57 million expected (FactSet). The Q3 performance is generally worse than expectation, triggering a decrease in stock price by around 7% on 20^th of Oct. On the other hand, Netflix gives higher Q4 forecast of 1.35 EPS than the Wall Street forecast of 0.94. Both Netflix’s and the Wall Street’s forecasts are less than the Q3 actual performance. Considering effects of both the flu and the pandemic as well as more indoor activities in the winter, earnings momentum for Netflix is likely to persist and cause future positive earnings surprise which forms one of the stock price catalysts.

Improved earnings quality: A bearish view is that earnings manipulation engenders biased upward financial performance of Netflix[1]. In Figure 1, we can clearly see dramatically rising net income but remarkedly deteriorating operating cash flow for Netflix before 2020. The expanded gap between these two measures means that stated profits are far more than their actual receipts of cash in their bank account, and the situation is not improved until 2020. This suggests a high likelihood of earnings manipulation for boosting the net income and company’s valuation. In contrast, Amazon, which is the most expansive stock among FAANG companies based on price-to-fundamental ratios, exhibits a heathier pattern that both net income and operating cash flow rise, while operating cash flow is greater than net income over time. Although Netflix’s business model is not completely comparable to Amazon’s model, this cross-company comparison helps us build a sense that a greater possibility of earnings manipulation for Netflix casts doubt on its particularly high valuation. For robustness check, I investigate another indicator of earnings manipulation, M-score of the Beneish model, and observe consistent patterns. If M-score is less than -1.78, it signals that a company is unlikely to be an earnings manipulator, vice versa. In Figure 3, from 2016 to 2018, M-score of Netflix is greater than -1.78 (the red line), implying that it is likely to be an earnings manipulator. By contrast, M-score of Amazon is always lower than -1.78 in Figure 4. In short, Netflix has an especially poor earnings quality with respect to its extremely high valuation in earlier time periods. However, Netflix seems to manage the earnings manipulation problem well and displays the incredibly shrinking gap between net income and operating cash flow in the first three quarters of 2020 in Figure 1. Additionally, Netflix’s M-score is below the red line in 2019 in Figure 3, alleviating investor’s concern. Netflix is on track to better earnings quality, deserving high valuations.

Figure 3: Netflix’s m-score over time

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[1] Netflix has a substantial amount of intangible assets, capitalizes them on balance sheets, depreciate them over time and report corresponding expenses in income statements. The choice of depreciation methods provides the company managers with great flexibility to manipulate earnings. It is interesting that Netflix still provides its DVD service shown on their website. One of the speculations is that they might avoid shutting down the service completely, reporting a huge amount of amortization and driving down their reported profits as well as valuations. Without solid evidence, this should be interpreted cautiously.