Despite having its best quarter yet, Wall Street seems to be disappointed with the earnings of Netflix $NFLX as future growth is not expected to be as great as the last two quarters.
2020 has been a great year for Netflix as the company added 26 million new users, including 10 million in the second quarter. The pandemic has been a boon to the business as more people spend time at home watching Netflix. And since, Netflix doesn't rely on ad revenues, the recession didn't have any negative impact on their business.
Netflix had record revenues for the second quarter with a 24.9% growth YoY and this is the second consecutive quarter, where Netflix had positive free cash. Out of the $6.15 billion in revenues, $899 million were converted into free cash flow compared to $162 billion last quarter. This is a massive improvement on the margins of Netflix but it is unlikely to continue as they are not expecting many new users in the third quarter.
As fast as the balance sheet is concerned, Netflix still has a good balance sheet with $15 billion in long-term debt and over $7 billion in cash and cash equivalents.
The main problem with Netflix remains that it cannot convert its huge revenues into free cash flow. Profits (Net income) doesn't mean anything if these are just paper-profits, what really matters is that the business is generating real tangible cash. With rising competition from Disney $DIS ,Amazon $AMZN and Apple $AAPL , which all can afford to lose cash over the short-term, the task is not that easy for Netflix ahead.
Ted Sarando has been named Co-CEO along with founder Reed Hasting yesterday. Ted Sarandos has been so far chief content officer of Netflix and we know that Netflix can produce quality content. It cost a lot of money, but they have proved that they can do it. Now Netflix will have to depend more on its own content as Disney and other networks launch their own streaming services. Ted Sarandos could very helpful to the future of Netflix.
As far as valuations are concerned, Netflix is still trading at over 100X Earnings. The problem with such huge valuations on a company is that investors wants more and more growth and once, the growth decelerates, they are disappointed. This is what we are seeing today with Netflix down 10% in premarkets. Netflix, however, is valued more on revenues than on profits. As far as the number of users grow, as far as they keep charging more for their services, the revenues will be growing. Netflix is currently being valued at 10X revenues and had been valued at X16 revenues in the past. Netflix already gained 60% in value this year and 375% over the past 5 years. It is hard to say whether the earnings shock is just temporary or not but when a stock has such huge valuations, I would be careful.