Stock splits are a good signal from management that a stock's strong price performance is justified and can continue.
This company has consistently executed a playbook that's turned it into a profitable cash-generating machine.
Two important factors make the business extremely appealing, even at its current all-time high.
When a company's stock splits, it doesn't change any of the underlying fundamentals of the company. Shareholders still own the exact same percentage of the businesses as they did before the stock split.
But enacting a stock split can be a very strong signal from management to investors. Management will usually initiate a stock split after a run-up in the price of the stock. When it announces a split, it's suggesting the current run-up in price is justified and that it expects the price to continue climbing.
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On the other hand, the confidence boost provided by a stock split will only go as far as the company's next earnings report or news item. If the fundamentals of the business are no good, or the stock has gotten ahead of itself, it doesn't make sense to buy it just because of a stock-split announcement.
One stock I've had my eye on looks poised for a stock split this year. It's up 284% since the start of 2023, and investors have an opportunity to get in now, whether management announces a split in the near future or not. Here's why investors shouldn't wait to buy Netflix(NASDAQ: NFLX).
Image source: Getty Images.
A best-in-class company with a soaring stock price
Netflix has followed a simple strategy over the last few years: Achieve a target operating margin while investing as much as possible in fresh content. Over time, details like earnings and free cash flow will sort themselves out.
Indeed, that's been the case. The company posted a whopping 31.7% operating margin last quarter and expects that to increase to above 33% in the second quarter. It notably kept its full-year target at 29% after releasing its first-quarter earnings report, suggesting more content expenses will hit in the second half of the year (when big-budget series debut and it broadcasts two NFL games). Still, 29% represents a nice expansion from the 27.4% it posted last year.
In the meantime, free cash flow has become more of a gusher. After a decade of investing heavily in original content and taking on debt, the company is producing billions in free cash flow each quarter. It generated a record $2.66 billion in free cash flow last quarter, and management expects $8 billion total for the year. The bulk of it will go toward share repurchases, increasing earnings per share for investors.
Investors have certainly noticed the expanding margins and ballooning free cash flow, sending the stock to a new all-time high after its most recent earnings report. Shares now trade well into four-figure territory, making it ripe for a stock split. Netflix management last split shares in 2015, enacting a 7-for-1 split on shares trading around $700 per share.
A bright future ahead
There are a couple of things that make Netflix an appealing company to own, even at its current price.
First of all, it shows strong pricing power. That's backed by its quality content and expansion into live programming. Continued price increases over the years haven't hurt subscriber growth very much. It flexed its pricing power significantly a couple of years ago as it cracked down on password sharing. And it's currently undergoing another round of price hikes this year.
Netflix finds itself in a virtuous cycle where it can use the additional revenue from price hikes to reinvest in additional high-quality content. Management expects to spend $18 billion on new content this year. That fresh content goes on to attract new subscribers and, just as importantly, keep existing subscribers paying more each month.
While Netflix has raised prices, it's also introduced a lower-priced ad-supported tier. The ad-supported tier gives consumers another way to pay for Netflix, and it presents huge upside for the business. That's especially true as Netflix takes greater control over its advertising technology. It implemented its own system in the U.S. last quarter, and it plans to expand that system around the world later this year.
Advertising represents a huge upside for Netflix over the long run. Few other streaming services have managed to capture the attention of their audiences like Netflix. It is the default streaming service for many, and as such, Netflix should be able to generate well-above-average revenue per user from its advertising tier relative to its peers. That should allow it to keep its ad-tier pricing low, increase its ad-free tier's pricing, and outperform the rest of the competition.
Management expects ad revenue to double in 2025 as it enters the "walk" phase of its "crawl, walk, run" strategy. This phased approach to implementing new initiatives starts with a limited rollout (crawl), gradually expands it (walk), and aims for full-scale implementation (run). It lets Netflix test, refine, and learn from each phase, minimizing potential risks. It could be off and running with the ad initiative by 2026.
Despite the strong growth outlook for the business, investors may think the stock is overpriced at its current valuation. Indeed, Netflix's forward price-to-earnings ratio of 44 makes it look very expensive. Its free cash flow yield of just 1.5% won't appeal to any value investors, either. But the long-term free-cash-flow generation for the business could climb substantially, and management will buy back shares, boosting its earnings growth.
That's why I'm holding my Netflix shares, whether management announces a stock split or not.
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