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On October 18 Netflix (NFLX) reported impressive Q3 sales and membership growth, and a massive free cash flow (FCF) rise. With its membership price hike plan going forward, FCF is set to grow. This makes NFLX stock attractive to value investors.
The company said that Q3 sales rose 10.7% YoY to $8.692 billion. That was also 1.76% higher than the $8.542 billion Q2 revenue.
Moreover, global streaming memberships rose by 8.76 million people in Q3 over Q2, a QoQ growth rate of 3.7% over the prior quarter. This was also 10.8% higher than a year ago.
Free Cash Flow Surges
But the most impressive news was that free cash flow (FCF). It rose from $1.339 billion in Q2 to $1.888 billion in Q3. That represents a QoQ growth rate of 41%, which is a staggering rise, especially if it continues, although that is not likely.
More importantly, this FCF represents a very attractive FCF margin and we can use it to forecast FCF going forward. For example, as seen in the table above, the $1.888 billion in FCF represents 22.1% of its Q3 revenue of $8.542 billion.
In addition, note that the company forecast that its revenue for Q4 will be $8.692 billion. So, if we apply a 22% FCF margin to that estimate, FCF could reach $1.912 billion.
In fact, analysts now project revenue next year will reach $38.25 billion, up 13.7% from 2023 estimates of $33.63 billion. So, if we apply this 22% FCF margin to that $38.25 billion FCF forecast, it shows that free cash flow could reach $8.415 billion next year.
Moreover, there is every reason to believe that the FCF margin could rise, given that the price rise next year will have little extra cost. That shows that the company has huge operating and FCF leverage.
So, in effect, we could forecast a 24% FCF margin. This implies FCF could rise over $9 billion (i.e., $38.25 b x 0.24 = $9.15 billion).
This is why value investors find NFLX attractive.
Forecasting a Target Price for NFLX Stock
For example, if FCF rises to $9 billion next year, the market is likely to give NFLX stock a premium valuation. Using an FCF yield of 3% Netflix could be worth as much as $305 billion. This is seen by dividing $9.15 billion in forecast FCF by 3.0%.
That is 71% higher than its present $178 billion market capitalization.
A more conservative estimate, using a 5% FCF yield, shows that NFLX stock is still undervalued. For example, dividing $9.15 billion by 5.0% brings a forecast of $183 billion. This is still 2.8% above today's market value.
So, in effect, NFLX stock is worth somewhere between $183 billion and $305 billion. As it becomes clearer next year that FCF is surging and could exceed $9 billion, the stock will rise.
On average its price target is $243 billion, or 36.5% over today's valuation. That puts the stock price target at $550.90 (i.e., 1.365 x $403.59 price today).
Short OTM Puts for Income
In my last article on Netflix on Oct. 6 ("Netflix Stock Still Looks Like Good Value for Value Investors") I suggested selling short out-of-the-money (OTM) puts and calls. So far that strategy has worked out.
It makes sense to roll these trades forward. For example, for the Nov. 10 expiration period, 21 days from now, investors can sell short the $380 strike price puts, which as over 5.4% below today's price of $403.59.
The premium received is $5.18, which represents an immediate yield of 1.36% for just 3 weeks (i.e., $5.18/$380). That also represents an annualized expected return of over 23% since there are 17 periods of 3 weeks in a year (i.e., 1.36% x 17) = 23.1%).
The bottom line here is that investors can expect to see a higher NFLX target price over the next year. One way to conservatively play this, along with owning NFLX shares, is to sell short OTM puts for extra income.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
