The Long and Short

Netflix free cash flow adds strength

| July 21, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Netflix’s (NFLX) paid sharing initiative has reignited subscriber growth, based on the company’s second quarter results. While revenues and operating profit lined up with the company’s forecast, the initiative should help fuel stronger revenue growth in the back half of the year. Management increased its full year free cash flow guidance to at least $5.0 billion, given the early success of the initiative coupled with the ongoing strikes in Hollywood. While the strikes are essentially a one-time event, with production set to resume after the strike, it is a cash flow boost that strengthens an already strong balance sheet for the ratings.

NFLX spreads have had a dramatic move tighter since the credit was upgraded to Investment Grade earlier this year by Moody’s. The current Baa3 rating has a positive outlook and an upgrade to mid-BBB could be another positive catalyst for spreads. Additionally, NFLX’s best in class net leverage should keep the credit trading through peers. There appears to be one dislocation in the front-end of the curve where NFLX trades wide to peer Fox Corp. (FOXA – Baa2/BBB). This relationship should reverse given NFLX’s stronger net leverage and cash flow metrics.

Exhibit 1: BBB Media Curve

Source: Bloomberg TRACE; Santander US Capital Markets

Fiscal second quarter results

Revenues for the quarter were up 2.7% to $8.2 billion while operating income increased 15.8%, to $1.8 billion. The operating margin expanded 250 bp, to 22.3%. While not the company’s strongest second quarter from a margin perspective, the margin moved much closer to the record 25.2% witnessed during the pandemic. Management noted that they expect revenue growth to accelerate in the second half of 2023 as they begin to witness the full benefit of its paid sharing initiative. In May, NFLX rolled out the initiative in over 100 countries, representing over 80% of its revenue base. The initiative led to 5.9 million of paid net additions in the quarter. Management noted that revenue in each region is now higher than pre-launch and that sign-ups are outpacing cancellations.

NFLX ended the second quarter of 2023 with a strong cash position of approximately $8.6 billion relative to $14.5 billion of total debt. EBITDA on a LTM basis totaled $6.5 billion, which translates to gross leverage of 2.2x and net leverage of 0.9x. FOXA, NFLX’s closest comp, has yet to report second quarter results but ended first quarter 2023 with gross and net leverage of 2.1x and 1.1x, respectively. FOXA is estimated post an EBITDA margin of 22.2% when it reports its quarterly results. This compares to NFLX’s EBITDA margin of 23.9% in the second quarter of 2023.

Exhibit 2: NFLX Quarterly Results (2Q22-2Q23)

Source: NFLX Company Report; Santander US Capital Markets

Fiscal third quarter and full year guidance

As seen in Exhibit 2, NFLX is guiding to revenue growth acceleration in the third quarter of 2023 with an expectation for 7.5% revenue growth on both a reported and FX neutral basis. Management noted that top line growth would largely come from growth in average paid memberships. Paid net adds for the quarter are anticipated to be similar to the net additions witnessed in the second quarter of 2023. Operating income is being guided to $1.89 billion, representing growth of over 23% from the year-ago period. That growth is expected to fuel an approximate 290 bp expansion in the operating margin for the quarter.

Management is still expecting the full year operating margin to be in the 18%-20% range, which would put margin growth in the 20 to 220 bp range from fiscal 2022. NFLX upped their free cash flow guidance for the year to at least $5.0 billion, up from previous expectations for at least $3.5 billion. While the strikes are a significant part of the upward revision to free cash flow guidance, management also noted that they are now past their most cash-intensive phase of their programming strategy. That said, they expect a positive growth trajectory for free cash flow over a multi-year period.

Large M&A not in the cards

As the media landscape continues to trend in the streaming direction, management was questioned on their use of their growing free cash flow base. While management is always looking for opportunities, they stressed that they have traditionally been a builder versus a buyer, and their views have not fundamentally changed. While certain media assets have become distressed and could provide an attractive buy opportunity, management was quick to note that most media assets are stressed for a reason. Any M&A focus would surround access to pools of intellectual property that can be used to for development.

Share gains in competitive streaming market

Since the pandemic, streaming has gained tremendous market share relative to its Broadcast and Cable television peers. While the streaming environment has grown highly competitive, NFLX continues to gain market share. Streaming share has witnessed over 10 percentage points of growth in the past two years at the expense of both broadcast and cable (Exhibit 3). Both NFLX and Youtube Inc. were able to maintain share at the top of the pack despite numerous competitors entering the market.

NFLX has noted that customer engagement has led to strong retention. NFLX understands that variety remains a key factor for its customer base and has been producing content across multiple genres, cultures and languages to meet demographic needs. Its success with subtitled and dubbed series has separated NFLX from other streaming peers. NFLX is finding that non-English language titles have been gaining popularity in the US, with multiple shows hitting Nielsen’s weekly streaming top 10 lists. ‘Squid Game’ is one clear example of this success.

Exhibit 3: US TV Screen Time Share (May 2021 to June 2023)

Source: NFLX Company Report; SanCap

Meredith Contente
meredith.contente@santander.us
1 (646) 776-7753

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