What Will It Take For Netflix To Continue Outperforming?

Netflix Inc NFLX has managed to stay afloat despite competition breathing down its neck. An analyst at Morgan Stanley dived deep into what is needed to continue driving outperformance forward.

The Netflix Analyst: Benjamin Swinburne has an Overweight rating and $700 price target for Netflix, with the price target suggesting roughly 12% upside from current levels.

The Netflix Thesis: Content leverage is the biggest opportunity for Netflix to have a profitable streaming future and for the shares to outperform, analyst Swinburne said in a note. Content is the company's largest area of annual investment, with content amortization running over 40% of revenues and cost of revenues about 60%, the analyst noted.

Netflix's margin needs to climb above the 40% gross margin to achieve the level of EBIT margins seen in scaled TV businesses of the past, the analyst said.

Related Link: Why (And When) Netflix Stock Could Reach $900 Per Share

The rapid transition to a vertically integrated and increasingly local production business, and the reloading of the content pipeline post-COVID-19 pandemic have both weighed down on gross margins of late, Swinburne said.

Content cost per member has been growing, although the mix has shifted from licensed to productions, as Netflix has built up its own studio, the analyst said. The studio build-up has been at a massive pace and it recently made a significant push into foreign language production such as South Korea's Squid Game, he added.

"The buildout of its own global/local studio will never be 'done,' but a lot of infrastructure has been put in place and Netflix has now spent several years ramping up the volume of content across genres and markets," the analyst said in the note.

This suggests this spending growth could slow, he added.

There has been a sharp resumption of content spend around the pandemic, as reflected by the $9.8 billion content on the balance sheet, either in-production or in-development, in the third quarter, the analyst noted. This will hit the income statement in 2022 and beyond, the analyst said.

Entering 2023, the leveraging of international production and the fading impact of the COVID-19 reload of content could lead to gross margin expansion and share outperformance, Swinburne said.

Netflix Games represents a potential reinvestment area in content that could push out content leverage, or limit it all together, the analyst said.

The strategy is to drive higher engagement through gaming, supporting lower churn and higher pricing power and ultimately leading to higher long-term earnings power, he added.

NFLX Price Action: At last check, Netflix shares were slipping 2.72% to $611.

Related Link: Netflix Cozying Up To Apple By Letting It Have A Share Of Gaming-Revenue Pie, Says Mark Gurman

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