netflix (NFLX -1.54%) the stock posted a nice little rally on the heels of the company’s Q2 2022 results. Share prices rebounded around 25% in the days following the quarterly report. Global subscriber losses and resulting revenue didn’t drop as much as expected, and shareholders were thrilled to make it a win.
But Netflix isn’t off the hook (at least not yet). Blame the historic rise of the US dollar against most other currencies. For Netflix’s business model, a strong US dollar is seriously hurting profitability. Until that headwind dies down, pioneering streaming stock isn’t as cheap as it seems.
The devastating currency effect on operating income
Despite a net loss of one million paying subscribers from the previous quarter, Netflix’s revenue actually rose 8.6% year-over-year in the second quarter. More subscribers compared to the previous year and higher subscription fees helped sales increase.
However, exchange rates reduced realized revenue by $339 million last quarter. Excluding currency, Netflix sales would have increased 13% year-on-year.
Shareholders have the dollar to thank for that. How? In an attempt to stem inflation, the US Federal Reserve aggressively raised interest rates to calm the economy. A side effect of the Fed’s action is a strengthening of the US dollar against other currencies. In fact, the dollar’s rapid rise was nothing short of historic as the Fed went from interest rates near zero to near 2% in a very short time. As of this writing, the dollar has risen about 15% against the euro over the past year and 25% against the Japanese yen. It’s a similar story for other foreign currencies.
When a multinational like Netflix makes a sale abroad, it must then convert that foreign currency back into US dollars for financial reporting and payment of expenses. When the dollar is rising against that foreign currency, it decreases the value of the initial sale. It’s a headwind that has impacted many other businesses lately.
However, the exchange is particularly problematic for Netflix. Due to the negative currency effect (plus $150 million in employee severance and real estate impairment costs), a modest year-over-year revenue gain in the second quarter was nearly 15% year-over-year decline operating profit to $1.58 billion. Free cash flow (operating income minus capital expenditures) was only $13 million.
The outlook for the third quarter is even worse as Netflix says 60% of its revenue comes from international markets, but almost all of its spending is in US dollars. Therefore, a projected 5% year-over-year revenue increase is expected to result in a 29% year-over-year decline in operating profit (compared to a 3% decline if the excluding exchange rates). This implies operating profit will only be $1.25 billion in the third quarter.
The headwind may reverse later, but watch out for the business model
Of course, this currency problem could turn positive at some point. If the Fed stops raising rates later this year or next — or if the Fed is even forced to start cutting interest rates again if the economy slips — the dollar could give back some of its gains against foreign currencies. In this case, Netflix could increase its revenue and profits.
But for now, exchange rates are proving to be a drag on what is already a low-margin business model. On a free cash flow basis, Netflix made a measly $140 million profit last year on revenue of $31 billion. (Net income was $5.1 billion last year, much higher due to the financial accounting of its content creation expenses in which it realizes those costs over time, compared to a payment initial lump sum for content when reporting free cash flow) .
In other words, Netflix may not be the cheap stock it seems (20 times past 12-month earnings per share at the time of writing). With the US dollar significantly higher than it was a year ago, profitability looks set to take a hit at exactly the wrong time.
Nicholas Rossolillo has no position in the stocks mentioned. Its clients may hold positions in the stocks mentioned. The Motley Fool has posts and recommends Netflix. The Motley Fool has a disclosure policy.