Netflix & Disney: Falling Knife vs. Hot Potato

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Netflix has 10 years of this very strong growth behind it, or more, and it's basically kind of caught up to them now. The other guys have pulled their content from Netflix, they've launched their own streaming services. They've not yet expanded as far as they will internationally, and they've not yet penetrated in the US as much as they will, whereas Netflix has probably fully penetrated in North America.

Hello and welcome to the Barron's Streetwise Podcast. I'm Jack Howe. The voice you just heard is Tim Nolan. He covers Netflix stock for Macquarie Research, and he told investors to stay away. This past week, Netflix shares imploded. So is it time to buy? We'll find out. Also, mortgage rates have jumped and shares of home improvement chains Home Depot and Lowe's have tumbled. One analyst calls that a buying opportunity. We'll hear why. Listening in is our audio producer Jackson. Hi, Jackson.

Hi, Jay.

That's either Jackson with a helium balloon or it's Meta. Hi, Meta.

Hi.

You're filling in for Jackson. He's on vacation. How are you? You have a baby now. How have things changed? What's new? Are you still drinking those wild flavors of Mountain Dew? What's going on over there?

No, I'm just drinking coffee these days. But I have gone from, you know, small batch artisanal coffee to buying just bulk coffee and drinking it by the gallon all day long.

That's a parenting power move.

It is.

We've talked in the past on this podcast about ready-to-drink cocktails, and a friend brought one over and left it behind, and so I started dipping into it. It says "party in a can" on the side, and it's a margarita, and it's the size of a scuba tank. And I don't, I don't remember the brand, but I remember it says on the side "serves 12." Whoa. What it also does is it serves one for like a week and a half.

So have you finished it?

Not yet, and I'm a bit sick of margaritas. I feel like I'm hearing mariachis in my sleep. Okay, Netflix.

All stock stories today pale in comparison to that of Netflix. Shares of the streaming giant losing more than a quarter of its value. Wow, take a look at that.

It suffered a stock plunge for the ages this past week. It fell 35% in one day after the company reported first quarter financial results that wiped out about $55 billion of the company's stock market value. It's roughly the same size as another streaming company, Warner Bros. Discovery, which owns HBO Max. To set the scene going into Netflix's report, the streaming business has, of course, gotten crowded. And producing new shows and movies is expensive. So expensive, for example, that AT&T recently spun off its entertainment assets so that it can spend more money on its phone network. Netflix shares had also looked both expensive and vulnerable. They peaked at $700 in November but had been falling heading into this year as it became increasingly clear that the Federal Reserve would have to raise interest rates to try to get inflation under control. There's a math model Wall Street sometimes uses to figure out what stocks are worth called discounted cash flow analysis. And the idea is to add up all the cash companies will generate in the future and put a price tag on it today. One key factor in determining that price tag is how long investors will have to wait for the cash flows to roll in. And another is what else they can do with their money in the meantime if they don't buy shares. Long story short, companies like Netflix, which generate little free cash today but are expected to bring in a lot in the future, are particularly vulnerable to rising interest rates. Back in January, Netflix stock fell more than 20% in a day after the company had issued weak guidance for subscriber growth. Investors weren't sure whether Netflix was being conservative with its guidance were suffering a temporary slowdown or if something worse was going on. Bill Ackman, a well-known hedge fund investor, bought more than $1 billion worth of Netflix stock back then, but an analyst we spoke with in this podcast, Tim Nolan at Macquarie Research, told us that he thought the stock might have further to fall. Tim was right. This past Tuesday, Netflix reported first quarter financial results and they were a mess.

Netflix's future seemed once as sparkly as an episode of Emily in Paris. Today, it's looking like something out of a dystopian drama, Squid Game.

Wall Street had predicted that Netflix would add 2.5 million subscribers during the quarter. Instead, it lost 200,000. That was the company's first subscriber decline in more than a decade. Now, part of it came from Netflix shutting off service in Russia. But even if we ignore that, Netflix would have gained 500,000 subscribers during the quarter, coming up 2 million short. And management estimated that during the second quarter, Netflix could lose 2 million subscribers. Remember, the high stock valuation was based on an expectation that Netflix will grow quickly. So after a second consecutive quarter of disappointment, it was look out below for the stock. It closed on Wednesday at $226. Should investors buy it? On Wall Street, that's called catching the falling knife— buying a stock so close to a recent plunge. As the phrase suggests, it's generally regarded as dangerous. Price momentum and operational momentum matter. Good news or bad news can beget more of the same. Bill Ackman, who caught the falling knife back in January because he thought the valuation looked attractive, Sold his shares this past week for a loss of about $400 million. So what would have to change for Netflix to look like a good deal for investors? I checked in with the guy who was right about the stock the last time around.

Hi, Jack.

Hey, Tim, how are you?

Fired. How are you?

I bet everybody wants a piece of you right now.

I bet it's a fun day.

That's Tim Nolan at Macquarie. Multiple analysts who were bullish on Netflix before Tuesday's report downgraded the stock. One bear upgraded it to a neutral rating. Tim started bearish and stayed bearish. I asked what he would need to see to take a more favorable view of the stock. He mentioned a shift back to healthy growth. Here's Tim.

They've announced basically two plans to get back into a better growth mode, and that is trying to convert some of the $100 million or so free riders on other people's subscriptions into becoming paying subscribers. And secondly, and related to that, is introducing this ad-supported tier, which is a major, major, major change for Netflix. It's something they not only resisted, but they were very vocally opposed to for their whole history until now.

The topic of account sharing for streaming services came up recently in a conversation Jackson and I had with our colleague Rebecca. She says she and her husband subscribe to all of the services and she shares.

We have literally all of them and I share them with all my friends because I hate that I'm paying for all of these and then I'm watching all these shows that my friends can't talk to me about. So I'm like, please just sign in.

Rebecca says the key is to make a separate user profile.

There's my profile, his profile, and then we have a guest profile and that's what we let anyone else use.

Oh, I gotcha.

Because I'm like, I also don't want you to mess up my binge and, you know, you're getting all UFC fighting episodes or something. Exactly. I'm not interested.

Netflix has 222 million paying subscribers, and it estimates that its service is being shared with 100 million additional users. Rebecca's plenty popular, but presumably those aren't all her friends. We can assume these users are fairly price sensitive, so one way to make money from them is to offer low price or free service with advertising. Tim at Macquarie says that's a good idea.

We actually think an ad-supported tier makes a lot of sense. We've seen success from companies like Discovery+, which have an ad-supported tier. If Netflix can, you know, A, attract more subscribers at a lower price, which makes it more attractive to consumers, And B, make more money out of them than on the other tier, then that is a win-win for both sides.

The problem is that Netflix says it could be a year or two before its ad-supported tier comes to market.

Maybe they're giving themselves some time. Maybe they are exaggerating how long it'll take and they'll surprise us coming with something sooner. But it seems to me like there is a lot of work to be done to set up an ad tier. There's a lot more infrastructure and technological capability and data management and all sorts of things that you have to do. So I don't know what the exact timeframe is, but if I had a good sense that, you know, the inflection was coming, that would probably get me more interested in the stock.

Tim covers other streaming companies. He's bullish on Walt Disney and the new Warner Brothers Discovery. That's the AT&T spinoff, which combined with Discovery Tim says Warner's HBO has a strong presence internationally and is close to a peak in content investments. In Tim's opinion, Warner has better content than Paramount, which he says will need to do a lot of investing over the next 3 years.

So to bring it together, it's slowing sub growth for Netflix. It's rising sub growth, I think, for Disney and for Warner Bros. Discovery, especially internationally. It's high content costs for everybody. And in terms of the earnings from the streaming businesses, everybody else unless it's not Netflix, still has a ways to go to get to actual earnings. Disney and Warner Discovery may be closer to that than some like Paramount, and I think that's probably why their cash flow is better.

By the way, Disney stock is down 32% over the past year, and that makes it by far the worst performing of the 30 companies in the Dow Jones Industrial Average. It's surprising because back in February, Disney reported record revenues and operating profits in its domestic theme parks. Its number of subscribers for streaming grew 37% at Disney+, 76% at ESPN+, and 15% at Hulu. So if parks are bouncing back nicely and streaming is strong, why has the stock been such a flop? One reason is that the struggles at Netflix might be reining in enthusiasm over just how large and profitable a streaming service can become. Investors might be gradually coming around to the view that streaming won't fully replace the profits lost in movie theaters and traditional television, at least not soon. That makes even legacy Hollywood companies look more speculative, which in turn could give them more exposure to rising interest rates. But there's another issue for Disney, and it's not one Wall Street wants to talk about. JPMorgan wrote this past week, quote, getting shares moving toward our target may require some relief of recent political headlines. By recent political headlines, it means a standoff between Disney and Florida politicians. That state's legislature just passed a bill that eliminates a special tax district that for now allows Disney World to provide its own municipal services and oversight for things like wastewater treatment and drainage and construction. If local governments take those functions over, operations for Disney World could become more complicated and expensive in a hurry. And breaking right now, the Florida Senate just passed the Parental Rights in Education bill. Now, the measure would prohibit classroom Relations between Disney and Florida's government soured after Florida passed the Parental Rights in Education law. Now, protesters gathered in the Capitol halls claiming that this legislation will marginalize gay students. Supporters, however, the bill say that children— which prohibits classroom discussion of sexual orientation and gender identity for grades 3 and under and limits it for older grades to material that is, quote, age-appropriate. That part of the law, critics say, is vague and subjective and could negatively affect already marginalized students. They have derisively labeled the measure the "Don't Say Gay Law," and they say it was created for political reasons. Supporters of the law say they want parents to have more of a choice over what's taught in schools. I'll leave that debate to others. If you're wondering how Disney got in the middle of this, It was silent on the matter and then faced a backlash from employees. So it came out and criticized the law and announced that it was suspending political contributions, which in Florida went overwhelmingly to Republicans who control the legislature and the governor's office. So when JP Morgan refers to political headlines, I suspect it means that it remains to be seen how this dispute will play out and whether Florida's legislature will take more actions to make things difficult or less profitable for Disney World. There are a lot of moving parts here. With Netflix and Disney's now lower stock prices, investors have a choice of buying either a falling knife or a political hot potato. And for now, many seem to be choosing neither. Meta, did I get through that part even-handedly and with sufficient caution? And could you hear the terror in my voice?

It might be time for you to strap on that scuba tank of margarita drink.

Bon voyage. Okay, coming up, we'll look at two more stocks that have underperformed, Home Depot and Lowe's, and why one analyst says it's time to buy.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.

Welcome back. A year ago, U.S. house buyers could get a 30-year mortgage with an interest rate under 3%, and now that rate is over 5%. Meanwhile, house prices are up 19% over the past year, judging by the latest reading on the S&P CoreLogic Case-Shiller Index. So put those two together. Imagine that a year ago you were looking at a $500,000 house with a 2.78% mortgage. You're a first-time home buyer, so you were going to put down 5% and borrow the remaining $475,000. Your monthly payment would have been $1,000 $971,000. I'm counting only principal and interest, not taxes, homeowner's insurance, or the mortgage insurance you pay to get the low down payment or anything else. Now, let's assume that you did not buy that house a year ago and that no one else snapped it up either. That's unlikely, I realize, but bear with me. Suppose the house had followed the national average path for prices. It would now sell for $595,000.

$500,000.

You're still putting down just 5%, but now your mortgage rate is 5.18%. And that means that the same house that would have cost you less than $2,000 a month if you bought it a year ago will now cost you more than $3,000 a month. $3,078 to be exact. House prices might be up 19%, but your monthly housing cost after factoring in your higher mortgage rate is up 56% in just a year. And that's what first-time homebuyers are talking about when they say that the deck seems stacked against them. Mortgage applications have plunged over the past year. Part of that is due to fewer homeowners wanting to refinance now that rates are up so much. But even mortgage applications for home purchases are down 14% from a year ago. And that has investors wondering which housing-related businesses are headed for a slowdown. Home improvement retailers have caught their attention. So far this year, Home Depot stock has lost 24%. Lowe's is down 19%. I recently spoke with Elizabeth Suzuki, who covers both stocks for BofA Securities and says this is a buying opportunity.

These stocks are at their cheapest valuations on a PE basis, a price-to-earnings basis, since March of 2020. And that turned out to be a pretty good buying opportunity at the start of the pandemic.

That was when we all thought the world was going to go kablooey in the early weeks of the pandemic, right?

Exactly. So now we've seen Home Depot at a PE below 19 times. We've seen Lowe's get to below 15 times. These are multiples that would indicate a much more draconian economic outlook than what we are expecting for the US consumer.

Consumer this year. There are two keys to Elizabeth's view. One is the observation that demand is holding up well. Home Depot and Lowe's won't report quarterly financial results until mid-May. But Elizabeth has access to real-time credit card company for the parent company she works for, Bank of America.

So anytime someone uses the Bank of America credit card to pay their electrician or their contractor or their plumber, it's being captured in that data set.. And what we've seen is that compared to pre-pandemic levels, that housing-related services spending is up over 60% versus 2019, and it has stayed incredibly consistent throughout 2022. So it really didn't see that drop-off in March that we saw in a lot of categories of consumer spending as gas prices were starting to rise and food prices were rising and consumers pulled back on some spending in other discretionary categories. The spending on, on professional housing-related services stayed very, very strong.

There's a second key to Elizabeth's bullishness on Home Depot and Lowe's. It's the BofA Reno Barometer. How do you go about making a Reno Barometer, renovation barometer? I'm guessing that you look at past— the history of spending on renovation, and then you look at all sorts of other potential clues and you see which ones tended to have predictive power in the past.

Am I warm? Yep. No, that's exactly what we did. So we were specifically looking at which macro factors had a high correlation with the same-store sales growth of Home Depot and Lowe's because we actually had that on a monthly basis going pretty far back. So we ran the historical correlations from 2009 through 2018 and filtered out the ones that actually had that high correlation. And in some cases they were leading by a few months. So we made those adjustments, but it was a fun modeling exercise.

Sides, actually. Elizabeth says that house prices were one of the strongest predictors she found. And remember, prices are rising quickly now. But what about home purchases? Elizabeth says that surprisingly, those aren't as important.

Yeah, so interestingly, housing turnover is probably not as big a deal as you might think. And I think that's one of the things that's driving the sentiment in the stocks these days is that, you know, in a rising rate environment, housing turnover is likely to be weaker, right? You know, rates go up, it's harder to get a mortgage that's affordable. So people kind of stay put. They stay in their homes. They don't put their home up for sale because they don't want to have to take on a mortgage at a higher rate. And that, that makes sense. But then when you think about the actual numbers of homeowners that are making that move every year, it's pretty small as a percentage of the overall housing base. Right. So, you know, in a given year, maybe like 5 or 6% of homes will change hands. But the other 94, 95% of homes are staying where they are. So those homeowners are continuing to make renovations. On their homes, which are on average over 40 years old and do need a fair amount of maintenance and repair.

Elizabeth says another thing that bodes well is the number of 25 to 54-year-olds, which is an age group that tends to spend a lot on home improvement. She says that between Home Depot and Lowe's, Home Depot is the more expensive stock, but the company also has a history of better execution, and Lowe's is cheaper and improving. Do you have a favorite between the two, or you like them both equally?

I mean, I have buy ratings on both of them, so I can't pick a favorite child.

Okay. As for which store is better, I can tell you from personal experience that preferences run strong and can differ among siblings and neighbors. I've already touched on one hot potato subject this episode, but even I know better than to weigh in on where best to buy a weed whacker. Thank you, Tim and Elizabeth, and thank all of you for listening. And thank you to the highly caffeinated Metalutzoff for filling in as our producer this week. Subscribe to the podcast, kindly write us a review on Apple, and I do mean kindly, and you can follow me on Twitter. That's @JackHough. See you next week.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.