01/21/22 11:35 AM EST

NFLX | HORSESHOES AND HAND GRENADES

Andrew Freedman, CFA

"Close don't count in baseball. Close only counts in horseshoes and hand grenades."

- Frank Robinson (Time magazine; July 31, 1973)

If you don't know by now, I am a big fan of proverbs. They distill the complexity of life's lessons into something simple and profound. "Close only counts in horseshoes and hand grenades" is a pithy way of saying "being nearly successful or accurate is not the same as being successful or accurate; being close to achieving something does not provide any benefit."*

Seeing Netflix (NFLX) blow up after reporting a disappointing outlook on subscribers and margins is bittersweet.

After being negative on the name since March of 2019 (Click Here) - getting run over through COVID (Click Here) - and doubling down in October 2020 (Click Here), last night's print suggests we were more right than wrong with respect to competition, market penetration, and margins.

However, we didn't have the short call on into the print - even though we thought there was a risk to FY22 sub estimates (Click here), and the data didn't look great (Click Here). Intellectually gratifying, sure. Financially disappointing, yes. I made a mistake and should have had this... Horseshoes and hand grenades.

Enough of the self-loathing.

We moved on from the short last year was because of the breakdown in the relationship between subscriber trends and the stock price (Click Here and see chart below). In retrospect, this was because the street was buying into the management's 2-year average growth and pull-forward narrative. Don't worry about 2021 net additions because we will comp out of it next year when our content slate ramps back up after COVID-related production halts. It made sense and was partially validated by the success of "Squid Games" in 3Q21 (I say partially because the reported metrics still didn't look great - Click Here).

However, the risk to the long was always that content spend would ramp back up and that subs wouldn't show up because of competition and market saturation. Paying more for less is generally not a good thing. AND that is what management's Q1 guidance for 2.5M 1Q22 implies. The 1Q22 guide was below the consensus estimate of ~6M but also below the ~4M they added last year. To provide some context on how bad this number is, if we annualized it based on Q1 seasonality of pre-COVID periods 2016-2019, it implies full-year net additions between 7.2 - 12.5M.

Even if we assume Q1 reflects a one-time, 1.5M churn headwind from price increases in UCAN (not a great sign in and of itself), we get to 11.5 - 20M net subscriber additions for FY22 (back to 2016/2017 levels). Either way, a meaningful step down compared to 18.2M in 2021 and the 27.8M added in 2019, and consensus estimates of 23-25M net adds per year into perpetuity. There are more puts and takes on sub drivers in Q4 and Q1, but we will leave that for another day.

For now, the 2021 narrative has been invalidated and investors are forced to take down their 2022 net add estimates and beyond. And for Netflix, that is a big problem since most of the equity value is based on an assumption of 500M+ subs in 2030. If they top out at 300M... or the pace of net adds is lower for longer, that is not good - and why the stock price correl with sub adds is working again.

Management acknowledged that gross acquisition growth is not back to pre-COVID levels and is not as fast as forecast. They also acknowledged that competition is having a negative impact on their marginal growth rate (something we have been saying since the beginning). Meanwhile, content amortization expense is finally catching up with cash content costs as production ramps back up - which combined with F/X headwinds will drive operating margins down 100-200bps YoY (vs. consensus expectations for up 200-300bps). Both the sub trajectory and margin headwinds are worse than even we were expecting.

As of this morning, the Factset consensus estimates for sub additions globally have come down to 19.5M in 2022 (from 23.5M), and out-year estimates 2023 - 2025 have come down to 20-22M per year (from 23-25M prior). These estimates still look too high to us, and we think they come down closer to 15M over time. Of course, if we follow the growth curve/s-curve AND we believe they are mature in many of their developed markets, it wouldn't be unreasonable to see net additions continue to take a step down each year in the future.

So what is a business worth - facing maturity, has yet to demonstrate an ability to scale costs (e.g., cash flow), and is missing estimates?

While the correlation to subscriber additions implies NFLX could trade sub-$100/share (there is no FCF and we believe content spend is equivalent to maintenance CAPEX), things would have to get A LOT worse on the subscriber front for us to get there. That isn't our base case.

If we anchor a base case to the ~20M net additions the street is modeling through 2025, we get a $400 stock (discounted at 7.5%). If subscriber results trend closer to our expectations, we get a $200 - $250 stock. If we go back to high 20s net adds (unlikely in our view), we can get a stock closer to $600. With the risk/reward more balanced, we will remove Netflix (NFLX) from the position monitor and contemplate our next steps.

CLICK HERE FOR OUR LAST BLACK BOOK ON NETFLIX

Chart 1: Netflix Subscriber Additions TTM to Stock Price