Netflix’s Ad-Driven Surge: Impressive Growth, Pricey Stock

Netflix (NASDAQ:NFLX) stock has had a pretty good year, rising by almost 40% year-to-date as the company successfully navigated a brief subscriber decline post-Covid-19. This compares to rival Disney (NYSE:DIS), which has gained about 12% over the same period. Netflix’s revival has been driven by its crackdown on password sharing and the expansion of its ad-supported streaming offering, which is helping the company cater to optimally monetize price-sensitive customers. In this note, we take a look at how the ad-supported strategy is playing out for Netflix.

The ad-supported tier is gaining traction, enabling Netflix to attract more price-sensitive customers. The ad-supported plan offers a solid value proposition for customers since it is priced at $7 per month in the U.S. This tier now boasts 40 million users, up from about 23 million in January. Netflix says that the ad-supported services represented about 40% of all its signups in the last quarter in markets where they are offered. Netflix is also looking to boost engagement of its ad-supported service by rewarding binge watchers by offering an ad-free episode after they’ve watched three previous episodes in a row. The company also raised the resolution of the ad-supported plan to full high-definition video quality, the same as its ad-free Standard plan. The company is doubling down on advertising technology, indicating plans to introduce its in-house advertising tech platform by the end of next year. This move will replace the Microsoft technology currently used to deliver advertising. Netflix is also looking for content that is better suited to advertising. For example, Netflix’s big push into live sports streaming could be explained in part by the need to grow its advertising business. Netflix plans to air two NFL games on Christmas Day in 2024, followed by at least one matchup in both 2025 and 2026. The company has rights to WWE Raw, as well as tennis, golf, and boxing events. It’s possible that Netflix would show commercials on these sports broadcasts, regardless of whether subscribers use the ad-supported plan or the ad-free plan. Moreover, the ad-supported plan is expected to generate more revenue per user than some of Netflix’s ad-free plans as incremental ad revenue more than offsets the discount offered on the ad tier. For perspective, Emarketer estimates that Netflix’s advertising revenue per user for the ad-supported plan will reach $70.50 in 2024.

NFLX stock has shown strong gains of 25% from levels of $540 in early January 2021 to around $670 now, vs. an increase of about 45% for the S&P 500 over this roughly 3-year period, as the ad-supported plans helped the company revive its growth rates following a post-Covid lull.  However, the increase in NFLX stock has been far from consistent. Returns for the stock were 11% in 2021, -51% in 2022, and 65% in 2023. In comparison, returns for the S&P 500 have been 27% in 2021, -19% in 2022, and 24% in 2023 – indicating that NFLX underperformed the S&P in 2021 and 2022. In fact, consistently beating the S&P 500 – in good times and bad – has been difficult over recent years for individual stocks; for other heavyweights in the Communication Services sector including GOOG, META, and TMUS, and even for the mega-cap stars TSLA, MSFT, and AMZN.

In contrast, the Trefis High Quality (HQ) Portfolio, with a collection of 30 stocks, has outperformed the S&P 500 each year over the same period. Why is that? As a group, HQ Portfolio stocks provided better returns with less risk versus the benchmark index; less of a roller-coaster ride as evident in HQ Portfolio performance metrics. Given the current uncertain macroeconomic environment with high oil prices and elevated interest rates, could NFLX face a similar situation as it did in 2021 and 2022 and underperform the S&P over the next 12 months – or will it see a strong jump?

Although we think that Netflix stock could move slightly higher if it beats earnings, we believe the stock is overvalued. At the current market price of about $670 per share, Netflix trades at roughly 40x forward earnings, which is a bit expensive in our view. While Netflix recent performance has been strong, with Q1 2024 earnings coming in better than expected, with its total subscriber base growing 16% year-over-year to almost 270 million users there are concerns.  Consumer spending growth appears to be slowing down, with the metric rising by about 0.2% in April after a rise of about 0.7% in March. Moreover, the unemployment rate in the U.S. has also seen a bit of an uptick coming in at 4% in May, up from 3.9% in April. These trends could weigh on players such as Netflix who are dependent on strong consumer confidence. Netflix could also see subscriber growth cool, as the impact of its accelerated subscriber ads coming from the twin impact of the password-sharing crackdown and ad-supported tiers is likely to eventually stabilize.  We have a $528 price estimate for Netflix, which is about 21% below the market price. See our analysis Netflix Valuation: Expensive or Cheap for more details on what’s driving our price estimate for Netflix. Also, check out the analysis of Netflix Revenue for more details on how Netflix revenues are trending.

[1] Returns as of 6/26/2024
[2] Cumulative total returns since the end of 2016

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