Netflix: Hybrid Strategy For Sports Streaming Is A Key Differentiator (NASDAQ:NFLX)

Investment Thesis

The last time I wrote about Netflix (NASDAQ:NFLX) (NEOE:NFLX:CA), I dissected the company’s Q1 numbers and made a case for why investors should focus less on the company’s decision to stop guidance on quarterly membership and more on the company’s deal with the WWE.

Since my article was published in April 2024, the stock has jumped 10.3%, outperforming the S&P 500, which gained 8.3% during the same period. I had a BUY rating on the stock.

In this article, I analyze the company’s Q2 earnings report and argue why the company’s hybrid strategy when it comes to sports should help it to stay ahead of its competitors. I also analyze the progress made by the company with respect to its ads business.

Second Quarter Highlights

Netflix had yet another impressive quarter, beating on both the top- and bottom-line estimates. Q2 revenues came in at $9.56 billion, up 16.8% y/y and beating analyst estimates by $28.2 million. Diluted EPS jumped 48.3% y/y, coming in at $4.88 and beating analyst estimates by $0.12. Global streaming paid net additions came in at 8.05 million, and while this translated to a growth of 36.6% y/y, they declined 13.7% sequentially. The company’s operating margins of 27.2% also came in above the company’s guidance and were about 5% higher compared to the same period last year. Free cash flows, however, experienced a marginal decline, coming in at $1.21 billion, compared to $1.34 billion during the second quarter of FY23.

The company raised its revenue and operating margin guidance for the full year. FY24 revenues are now expected to grow between 14% and 15%, compared to the previous range of 13% to 15%. FY24 Operating margins are now expected to come in at 26%, slightly higher than the prior estimate of 25%, on account of “improved revenue outlook and ongoing expense discipline.” The company expects paid net additions to be lower on a y/y basis, and has attributed it to the “full impact from paid sharing.”

Netflix is Taking Sports Seriously But is Not Breaking the Bank in the Process

One of the key takeaways from NFLX’s latest quarter has been the progress it has made with live sports. I had already talked about the company’s deal with the WWE in my last article, although one could argue that WWE is live entertainment and not exactly sports. This quarter, we got more updates regarding the company’s plans for live sports, when management mentioned the company’s deal with the NFL to stream two Christmas Day games, which was announced earlier in May. In addition, the company has also bagged the rights to livestream at least one NFL Christmas game in 2025 and 2026 with the option of a second game. And the games the company will be streaming this Christmas have the potential to draw a big audience as they involve the defending champions Kansas City Chiefs versus Pittsburgh Steelers, and Baltimore Ravens taking on the Houston Texans. All four teams made it to the playoffs last season, and the latter game would be a repeat of last season’s AFC Divisional Playoffs, so it is sure to attract a wide audience. As such, for a NFLX first, the company has certainly secured blockbuster content, one that has incredible potential to drive subscriber growth in my opinion.

Moreover, I like NFLX’s live sports strategy. The company is focusing on bagging one-off events, which means that it doesn’t have to break the bank or be beholden to any organization, unlike its peers. Google parent, Alphabet, for instance, signed a $2 billion a year deal with the NFL to stream Sunday ticket games for seven years, starting from 2023. Apple, on the other hand, signed a 10-year deal with Major League Soccer, for $2.5 billion. NFLX, on the other hand, paid $150 million for the Christmas games. By being selective over live sports, NFLX can reap the benefits of streaming mega sports events without having to write big cheques.

When it comes to sports, it’s not just live events that NFLX is focusing on. It has also ventured into what it calls the ‘storytelling version of sports.’ The company’s latest release Receiver is an example. It follows the 2023 season of NFL receivers Davante Adams, Justin Jefferson, George Kittle, Deebo Samuel, and Amon-Ra St. Brown, and is created by the same people behind another sports storyteller Quarterback. It also released Together: Treble Winners earlier this year, which follows the record-breaking 2022-23 season of Manchester City, when they won the Treble (Premier League, FA Cup, and Champions League). The Roast of Tom Brady, while not a sports documentary, also had NFL flavor to it, and was the company’s biggest live-streaming event yet, with 22.6 million views.

This hybrid strategy surrounding sports, which features both live sports and sports documentaries, in my opinion, is what would be the next growth catalyst for the company. Given that the company has made its intentions clear with respect to the ads business, which I’ll cover in more detail in the next section, live sports were always going to be needed for NFLX, especially since its competitors have already ventured into the space. But this hybrid strategy involving live sports and sports documentaries, in my opinion, should help the company stand out from its peers.

Ads Business Still in Early Stages but Continues to Show Promise

The other takeaway from NFLX’s current quarter was the progress made in the ads business. Q2 saw ads tier membership grow 34%, on a sequential basis and the company also announced that it was building an ad tech platform in-house, which it plans to test in Canada this year before launching more broadly in 2025. The company, during the earnings call, announced new features like the “pause” or “keep watching” ads, and cited deals with big brands including the likes of Expedia and McDonald’s. The new in-house ad tech platform is expected to offer prospective advertisers more ways to measure impact as well as offer more insights.

The company has already announced that the ads business will have no material impact on revenue growth this year or in the next, which signals that it still continues to be in the early stages. According to consensus estimates from Visible Alpha, the company earned about $800 million in ad-supported revenue in the first half of the year, which accounts for a mere 4% of the company’s sales. However, by signaling its intention to build the platform in-house, joining its rivals such as Disney, Amazon, and Paramount+, it does send a message to prospective advertisers to take the company more seriously when it comes to advertisements. Furthermore, the company is also seeing similar engagement for its ads plans compared to its non-ads plans, which is more evidence that when it does scale up the ads business, it has the potential to be a meaningful driver of revenue growth. Add to it that the company has promising avenues for advertisers, such as the NFL games and the WWE deal, and it does show the potential for this business to be a meaningful catalyst in the future.

Now that the impact of password-sharing slowly dies down, attention will quickly shift to the ads business. The fourth quarter would offer a good measure of how this growth catalyst is progressing, given that the Jake Paul vs Mike Tyson boxing match and the NFL Christmas games are happening around this time. As such, in my opinion, investors shouldn’t judge the company’s ads business too harshly at this stage. It may be nascent, but it most certainly is showing signs of progress with each passing quarter.

Valuation

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Source: LSEG Data (formerly Refinitiv), Seeking Alpha, Author’s Projections, and Company’s Q2FY24 Letter to Shareholders

As mentioned earlier, the company boosted its revenue guidance for FY24 and now expects revenue growth in the range between 14% and 15%. Given the company’s content slate and blockbuster live sports events such as two NFL games on Christmas Day and the Mike Tyson vs Jake Paul celebrity boxing match, I believe that the company will have a strong revenue growth. As such, I have assumed the high end of the company’s guidance, which is 15%, for my calculations, slightly higher than my previous estimate of 14%. At this rate, FY24 revenues are expected to come in at $38.75 billion, slightly higher than my previous estimate of $38.4 billion.

Management now expects FY24 operating margins to come in at 26% (vs. the previous estimate of 25%), which I believe to be a reasonable estimate, given how the company has been managing its expenses. Therefore, I have assumed FY24 operating margins of 26%, which translates to $10.07 billion, higher than my previous estimate of $9.61 billion.

I have left my assumption for the non-operating expenses for the company unchanged at $680 million. I have assumed the effective tax rate to be 13.3%, which is the company’s tax rate for the trailing twelve months. This is slightly lower than my previous estimate of 13.5%. Taken together, this would result in a net income of $8.14 billion, higher than my previous estimate of $7.72 billion. According to LSEG Data (formerly Refinitiv), the number of shares outstanding, in free float, amounts to 425.93 million. At a projected net income of $8.14 billion, this would result in an FY24 EPS of $19.11, higher than my previous estimate of $18.05, and implying an EPS growth of 59% y/y.

The company, according to LSEG Data, currently trades at a forward P/E of 30.3x, which is close to its historical 2-year forward P/E multiple of 29.7x. I have maintained the same rationale since my previous article on why I have assumed a forward P/E of 30.3x for my calculations rather than its 5-year historical forward P/E median of 40.3x. More specifically, in my opinion, NFLX is no longer the kind of hyper-growth company. It’s a company that’s evolving into a steady growth company that focuses more on profitability rather than “growth at all costs.” At the same time, given its leadership status and the various new revenue opportunities that it’s pursuing, the company does command a much higher multiple than the industry median of 17.9x.

According to Seeking Alpha, the company’s forward PEG ratio stands at 1.13, which would translate to an EPS growth rate of 26.81% for FY25. Given that I expect competitors to be better placed next year, and given that the company would be doing everything it can to ensure that the ads business becomes material in FY26, I do expect the EPS growth rate to come down next year. As such, an EPS growth rate of 26.81% is a reasonable estimate in my opinion, which translates to a projected FY25 EPS of $24.23.

At a forward P/E of 30.3x and a projected FY25 EPS of $24.23 results in a price target of $734, which represents an upside of approximately 16% from current levels.

I have increased my price target ($734 vs $665) since I believe that the competitive landscape for NFLX continues to remain weak, and while the ads business will remain immaterial to the company, this should be more than offset by the demand for its diversified content, especially now that it has ventured into live sports in a more meaningful manner by adding the 2 NFL games on Christmas Day (one of which, involves the defending champions Kansas City Chiefs). Due to these catalysts, my projected EPS for FY24 has increased, on account of a higher revenue growth and a higher operating margin assumption. I maintain my BUY rating on the stock.

Risk Factors

My risk factors are largely the same as last time. First, the deal with the WWE could fall short of expectations. Before that, the company will also have to navigate 2 NFL games on Christmas Day. Any glitches in the streaming of those events could lead to a muted response for the WWE deal, thereby impacting revenue and subscriber growth negatively.

While the competitive landscape remains weak for now, it doesn’t mean that others are not catching up. We still don’t know the full details about the Disney-Warner Bros.-Fox bundled live sports streaming package, and with Paramount being finally bought by Skydance Media, led by a young executive David Ellison, and backed by his billionaire father Larry Ellison, its streaming business could also improve in the future. The uncertainty about how the competitive landscape will evolve going forward is also a factor that investors need to account for.

Finally, as mentioned earlier, NFLX is building its own ad-tech platform and plans to launch in Canada later this year. The company would need it to be successful if it wants its plans of scaling up its ads business to be a meaningful contributor by FY26 to succeed. As such, this is yet another area where investors need to keep an eye on, especially since ad metrics are likely to be more important going forward after the company stops offering quarterly membership numbers.

Concluding Thoughts

NFLX had yet another good quarter, although weak guidance related to Q3 subscriber numbers dampened the mood. The company, once again, beat the top and bottom-line estimates and also raised the full-year revenue growth and operating margin guidance.

The company’s ads business is progressing well, with yet another sequential jump in subscribers for its ads-tier and with similar engagement being seen in both its ads-plan and non-ads plan. The company also announced that it’s building its own ad-tech platform, which should attract more advertisers in the long run.

The company also outlined its plans for live sports, with the streaming giant bagging two NFL Christmas games this year. But what I really like about the company’s sports segment is the hybrid strategy that it has adopted, blending live sports with sports documentaries. This unique strategy helps the company to expand its sports streaming without having to break the bank.

As the company ramps up its ads business, live sports is a must-have. However, by mixing sports documentaries with live sports, NFLX continues to bring its own flavor to sports streaming. It is this ability to set itself apart constantly that is going to make it very hard for competitors to knock it off the top.