Viewers of streaming service Netflix (NASDAQ: NFLX) may love some good drama, but the same is probably not true of most of the company’s shareholders. After crashing following last week’s earnings statement, the Netflix share price has continued falling. It hit a 12-month low in today’s trading and is 60% down on a year ago.
Here is why I have started buying Netflix for my portfolio.
Separating the signal from the noise
The earnings report was badly received, although in my view it contained mixed results. While subscriber numbers fell, that was driven by an exit from the Russian market. Without that, the subscriber growth number would have stayed positive.
That does not mean that the fall is not a problem. Whatever the reason, a fall is a fall. I think the bigger worry among investors is what comes next. The company said it expects to shed 2m subscribers in the coming quarters. The streaming market has attracted a lot of new competitors, putting further pressure on Netflix. That could hurt future revenues badly.
But I think it is important to separate the short-term noise from the long-term signal. The rush of competition shows that Netflix has hit upon a lucrative market, in which it enjoys high brand recognition and a large installed customer base. It is also good at monetising what it has. First-quarter revenue grew 9.8% compared to a year ago and the company expects double-digit percentage year-on-year revenue growth in the second quarter. In other words, the company has grown its user base massively in recent years but still expects strong revenue growth — even in a more crowded field.
Netflix as a cash cow
A common problem for growth companies is that an industry matures and growth slows down. I think that is happening now in developed streaming markets, although globally I continue to see lots of new opportunities for Netflix to add subscribers.
That could mean that Netflix moves over time from growth mode to being a cash cow. It could profit from its large customer base over time by increasing prices. While that may cause some users to abandon it, if enough subscribers do not cancel then Netflix could still make healthy profits. That has basically been the business model of US cable television for decades.
Netflix could also improve profits by cutting its cost base. Each year its library of past productions grows. So it may be able to produce less new content, saving a lot of money, while staying attractive to subscribers. Striking the right balance between pricing and offering attractive new content is a fine art. But Netflix has demonstrated that it understands its market dynamics very well.
My move on the Netflix share price
In the long term, I think Netflix’s proven business model and proprietary content could enable it to be a cash cow. That could help earnings increase markedly. The price-to-earnings ratio of 18 could become even more attractive if earnings increase.
I think the fall in the Netflix share price underrates the attractive economic characteristics of its business model from a long-term perspective. That is why I see it as a bargain right now and have bought it for my portfolio.
