Netflix's subscriber loss sell-off: Should you really ditch the stock?

The top streaming service just confirmed what investors had been fearing the most.

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This article was originally published on All figures quoted in US dollars unless otherwise stated.

With the release of its second-quarter financial results, Netflix (NASDAQ: NFLX) reported a net loss of 1 million subscribers in the quarter ended June 30. And this followed a loss of 200,000 customers in the first quarter of this year. For a business that has relied heavily on growing its user base over the past decade, this is not what investors want to see. 

Along with the broader market sell-off, spurred by high inflation and rising interest rates, shares of Netflix have fallen 64% in 2022. Is it time to sell this top streaming stock amid recent weakness in fundamentals? Let's take a closer look. 

A better-than-expected quarter 

Three months ago, Netflix's management, led by co-CEOs Reed Hastings and Ted Sarandos, had predicted a loss of 2 million subscribers in the just-ended quarter, so the company's official results were better than those expectations. Nonetheless, this trend of losing customers is not what shareholders want to see, especially for a business that has rapidly grown its viewership since introducing streaming in 2007. 

In the UCAN region (U.S. and Canada), representing 33.2% of Netflix's user base and 44.4% of its overall revenue in the latest quarter, the company lost 1.3 million subscribers. This marks the second consecutive three-month period (and third in the last five) that Netflix has shed viewers in the lucrative region.

Many Netflix bears are looking smart right now, since they have been calling the UCAN market completely saturated. The positive is that the average revenue per membership in the region increased 10% year over year. 

Netflix's overall revenue jumped 8.6% year over year in the second quarter, which was lower than the 9.7% management had hoped for. Were it not for the strong U.S. dollar, a factor that hurts companies that generate sizable sales internationally, Netflix's revenue would have increased 13% in the quarter. But either way you slice it, this growth is far lower than the double-digit gains investors are accustomed to seeing. 

Management is focused on two primary areas to propel the business and accelerate much-needed growth. The first initiative, well documented in recent months, is the planned introduction of a cheaper, ad-supported tier in early 2023. Netflix has chosen to partner with Microsoft on this strategic endeavor. Hastings has shunned this move in the past, but I believe it can attract more members, particularly price-sensitive ones. 

And although password-sharing among households once wasn't really discouraged by management, cracking down on it has now turned into a revenue opportunity. Netflix estimates that there are more than 100 million households worldwide that use other accounts' passwords for access to the content catalogue. Finding ways to convert these to paying subscribers could support increased sales. 

On a positive note, Netflix expects to add 1 million customers in the current quarter, returning to growth. 

What should investors do? 

For long-term shareholders of Netflix, the initial reaction to two straight quarters of subscriber losses is probably to sell. The business is not exhibiting the fast growth everyone is used to seeing.

But there are still some reasons to be optimistic. I don't think anyone doubts that streaming entertainment is going to continue taking share from linear TV in the decade ahead. And Netflix, with its first-mover advantage and 220.1 million accounts today, is the clear leader in the space. According to data from Nielsen, Netflix accounted for the most TV viewing time (over 1.3 billion minutes) by far in the U.S. in the almost eight-month period from late September 2021 to early May 2022. 

While subscriber additions and revenue growth were the key factors that investors cared about before, Netflix is now positioning itself for a different financial future. The operating margin for 2022 is forecast to approach 20%. And thanks to both an optimized cost structure and more-controlled content spending, the business is projected to generate positive free cash flow this year, with a significant jump in 2023. 

With a price-to-sales ratio of just 3.2 as of this writing, which is substantially lower than the trailing-10-year average of 7, it's safe to say that pessimism has never been higher. This presents a potential buying opportunity for shrewd investors. 

Despite the recent weakness, Netflix looks like a compelling investment. It is still a leader in producing great content, the upcoming ad-supported tier should help to boost growth, and the valuation looks attractive right now. Investors who are considering ditching the stock should take a closer look. 

This article was originally published on All figures quoted in US dollars unless otherwise stated.

Neil Patel has positions in Microsoft. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Microsoft and Netflix. The Motley Fool Australia has recommended Netflix. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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