Why you should avoid Netflix stock right now

Netflix (Netflix Stock Quote, Chart, News NASDAQ:NFLX) has been a market favourite over the COVID-19 period, thanks to positive momentum tied to the new stay at home economy. But even though the company has had years to prove its mettle, investors should be wary about owning the stock based on promises of huge earnings down the road.

So says Jennifer Radman of Caldwell Investment Management.

Head of investments and senior portfolio manager at Caldwell, Radman says a key indication on how the market has been valuing Netflix came after its latest quarterly earnings in July. There, the streaming content provider saw its share price slide a bit when its second quarter results came out. Netflix did fine on revenue at $6.15 billion for its Q2 but earnings of $1.59 per share were below analysts’ consensus expectation at $1.81 per share, with the company chalking up the lower profit in part to a one-time charge in California on R&D tax credits.

But it was the company’s take on the road ahead that apparently spooked the market, with management calling for weaker subscriber growth for the upcoming third quarter, saying in a letter to shareholders,

“[Growth] is slowing as consumers get through the initial shock of COVID and social restrictions. Our paid net additions for the month of June also included the subscriptions we cancelled for the small percentage of members who had not used the service recently,” management said.

Netflix forecasted net subscriber additions to grow by 2.5 million compared to the consensus expectation of 5.27 million. Thus, even with fairly rosy numbers the testy response was an indication of the narrow path to prosperity Netflix needs to walk for the next few years, according to Radman, who spoke on BNN Bloomberg on Wednesday.

“Expectations were really high in the second quarter and so even though they had a blowout quarter,” Radman said. “They had ten million new subscribers but the street was expecting eleven, and since then you’ve seen this stock sort of sell off.”

“I think it gives you a sense of the mindset of the market. It’s certainly a “build it and they will come” type of stock where you’re not necessarily buying what you have today but what you can have five years down the road and this assumption that all of a sudden you’re going to have this great cash flow profitability and so forth,” Radman said. “Netflix is definitely in that camp.”

“They’re looking to remain heavily spending on content to the point where free cash flow is really not expected to be positive until 2024. Disney+ is really in that same boat where they’re not expecting to break even on that platform until 2024. And so, we’ve never really been big fans of those types of models, just because we’ve seen in past history where if you pay today for what’s supposed to happen a few years down the road, and if that doesn’t materialize, that’s when you can get some pretty substantial capital losses.”

Netflix hit an all-time high of $575 per share in July this year, with the stock currently in the mid-$530s and sporting a year-to-date return of 66 per cent.

The company was free cash flow positive for both its Q1 and Q2 2020 and at the end of the second quarter had over $1 billion in net cash from operating activities. In order to support its growth and content demands, Netflix has had negative cash flow every year for the past decade until 2020. In terms of subscriber growth, the Asia Pacific region has been its fastest growing, although it currently supplies only one tenth of the company’s revenue.

Radman said the need to keep spending on producing new shows and movies to expand its subscriber base is a problem investors should be wary of.

“The increasing competition and this continual fight for subscribers and subscriber growth and the only way you get that is through content, which costs a lot,” Radman said.

“It makes it seem like that wheel that just keeps spinning and that treadmill that keeps getting faster and faster.”

“For that reason, we’re not really fans of the stock and not long in any of our portfolios,” she said.

Netflix does have its admirers, however, many of whom see the pandemic as prime time for the company to make hay. This week, Pivotal Research analyst Jeffrey Wlodarczak increased his price target from $600 to $650 on Netflix with a “Buy” rating, representing, at press time, a projected return of approximately 28 per cent.

Wlodarczak said in an update to clients that despite the surge in competition in the streaming space over the past couple of years Netflix is likely to remain “the dominant subscription video on demand player for the foreseeable future.”