40 million reasons why Netflix is ​​a screaming buy

Does anyone else have fond memories of walking into a Blockbuster on a Friday night, grabbing a handful of movies, and coming home to watch them? While there was nothing novel, per se, about the idea of ​​a video rental store, there was something magical about the experience of patronizing one. Maybe it was the anticipation of knowing whether or not the movie you wanted was available, or maybe it was the excitement of flashing your membership card like a badge of honor.

Whatever the case may be, it’s hard to believe it’s been roughly two decades since video stores dotted every city in the country. While streaming video on your TV seemed like a futuristic fantasy, it has become one of the fastest ways people create and consume content.

Netflix (NFLX 3.07%) pioneered this concept in the late 1990s and quickly became the market leader in transmission. However, the feature of giving viewers the option to watch their favorite premium cable shows without subscribing to cable is no longer a differentiating factor. In recent years, media and entertainment companies such as Disney, Amazon, Discovery of Warner Bros.Y Comcast all have introduced unique streaming services in an effort to capitalize on this trend. Netflix’s results to date have shown that competition is fierce and that the company must do something to regain its position as market leader.

Netflix makes a sacrifice

During the Q2 2022 earnings call, the metric that arguably worried investors the most was total Netflix subscribers. As of the second quarter of 2022, the company had approximately 220.7 million subscribers, which represented a decline of about 1 million customers since the first quarter. While Netflix’s decision to shut down use of the platform in some geographic regions due to ongoing political tensions may have influenced churn, most of the subscriber declines can be attributed to the company’s periodic price increases.

Douglas Anmuth, analyst at JPMorgan, asked management about the effectiveness of these price increases and received an interesting rebuttal. Netflix COO Gregory Peters said: “We’ve pretty much seen the standard response that we’ve seen historically over the last five years, which is that we typically have this adjustment period where there’s a slightly higher churn after the change of price.” He went on to say, “But then, if we do a good job of basically taking those price changes, which are significantly positive for net income, and investing them in more great content and product experiences.”

This is a really interesting paradigm. Effectively, Peters says that Netflix is ​​willing to sacrifice a specific cohort of its user base in the form of lost subscribers. However, customers who remain on the platform and pay the higher monthly rate far outweigh the lost revenue from churn, allowing Netflix to invest in more product features and premium original content.

A person streaming on a tablet.

Image source: Getty Images.

What does Wall Street think?

Netflix has been hinting about offering an ad-supported tier for some time now. The idea is that many other streaming competitors offer a lower cost option with ads or a premium subscription without ads. Mark Mahaney, Research Analyst at ever core, believes an ad-supported offering is the most obvious catalyst there is for Netflix. During a recent interview with CNBC, Mahaney stated that his market surveys suggest that Netflix could recover 20% of its broken base. His models suggest that if Netflix manages to capture 10 million paid subscribers, this could equate to up to $2 billion in annual revenue.

While these models are sensitive to assumptions about the variables, Mahaney’s research doesn’t seem too far-fetched. about a month ago, the Wall Street Journal reported that an internal Netflix market survey showed the company reached an additional 40 million unique viewers within a year of launching the ad level. If the standard Netflix subscriber is a household of four, then Netflix’s internal estimates also appear to be in line with Mahaney’s independent research.

Anmuth has also conducted his own surveys and just this week released a report suggesting that Netflix could acquire 7.5 million subscribers in its new ad tier. While this is slightly lower than Mahaney’s research, the initial general consensus among big-name financial institutions is bullish.

Beware of the valuation

While Netflix shares are down more than 60% year-to-date, the shares are up a bit in the past three months when the company’s second-quarter earnings were released.

Launching an ad-supported level definitely comes with risks. For example, Netflix may not embed ads in a way that audiences will accept, leading to lower conversion, click-through rates, and revenue. Still, some on Wall Street believe Netflix is ​​well positioned to regain market share and diversify its product offerings.

With a 19x price-to-earnings ratio, Netflix can be a bit rich on valuation. Cautious investors are better off waiting until the company releases third-quarter results next week. The company is likely to comment on the launch of its ad tier and channel partners.

For long-term investors, if the Q3 call indicates positive momentum around the ad launch, soon could be a good time to lower your cost base or start a position.

JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Adam Spatacco has positions on Amazon. The Motley Fool has positions and recommends Amazon, JPMorgan Chase, Netflix and Walt Disney. The Motley Fool recommends Comcast and Warner Bros. Discovery, Inc. and recommends the following options: $145 January 2024 Long Calls at Walt Disney and $155 January 2024 Short Calls at Walt Disney. The Motley Fool has a disclosure policy.

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