As a last ditch effort, some companies have dramatically changed their business models to create a new growth wave. Netflix (NFLX 0.22%) I recently tried this, and the results leave a lot to be desired. In 2023, Netflix made two changes that challenged its long-term business model: an advertising category and a strict password-sharing process.
After investors got a glimpse of what the new Netflix looked like during its second-quarter earnings results, the changes don’t seem to have the impact the company was looking for. As a result, many investors are likely wondering if it’s time to let Netflix shares go that high. So let’s take a look at Netflix’s performance and see if it’s worth sticking with.
Netflix’s new initiatives have not had the intended effect
Netflix’s revenue growth has been disappointing over the past year. It hasn’t grown its revenue by 10% or more in any of the last four quarters, and second-quarter growth of 2.7% kept that lousy streak going. While management has given guidance that business will pick up in the third quarter (guided by a 7.5% increase in revenue), it still isn’t enough to propel Netflix into growth-hit-market territory.
NFLX revenue data (QoQ growth) by YCharts
This isn’t very interesting, as a crackdown on password sharing and ad-level rollout movements should have had a more significant impact. However, management cautioned investors against jumping to conclusions too early, as it believes the second half of 2023 will be more representative of the revamped business model going forward. This appeal for patience, while reasonable, may be met with skepticism by some investors because these initiatives have already been in effect for several quarters without the expected results.
On a positive note, Netflix’s operating margin came in strong for the second quarter at 22%. This is crucial as Netflix is transitioning from a growing company to a more established company where profits matter most.
With that in mind, Netflix expects to post a full-year operating margin of between 18% and 20% (Q4 is historically a low point for operating margins for this company). This will likely translate into a profit margin for the mid-teens at the end of the year.
However, with this level of profitability and growth, Netflix stock seems overvalued.
Netflix is trading at a high price
If Netflix grows 7.5% in Q3 and Q4, that would give it full-year revenue of $33.3 billion. With a profit margin of 15%, that would generate profits of $5 billion. Netflix’s $192 billion market capitalization puts the share price at 38 times full-year earnings. Compared to a forward price-to-earnings (P/E) ratio of 20 times the market, Netflix has a significant premium over the broader market.
So, investors should ask themselves: “Is the company growing at about twice the market’s below-market pace?” For me, the answer is “no”.
Essentially, Netflix would have to double its earnings to get back to its average price-to-earnings rating. Even if Netflix grows 10% in the market at an average pace (which hasn’t happened in over a year), it would still take about seven years to achieve that.
There are many ways to double your revenue, including getting new subscribers and increasing prices. However, with Netflix bending over backwards to generate new subscribers (by cracking down on password sharing) and owning one of the pricier streaming services available, there isn’t much room for growth.
As a result, I think investors are best served by moving on from Netflix stock, especially after they’re up 45% this year. While I could be wrong, I don’t foresee a scenario where Netflix becomes an outperforming stock in the market given its high value and low growth. There are a lot of attractive stocks in the market right now, and I think the capital invested in Netflix will be better served by spreading it out to other areas.
Keithen Drury has no position in any of the stocks mentioned. The Motley Fool has and recommends positions on Netflix. The Motley Fool has a disclosure policy.
