Netflix Engagement Growth Is Slowing. Here’s Why I Bought More Anyway.

Netflix (NASDAQ:NFLX) is seeing a decline in the number of hours its members watch. The company's What We Watched report showed a 2% year-over-year increase in total viewing hours in the first half of the year.

While Netflix stopped reporting subscriber numbers, it's a good bet that it added more than 2% in subscribers in that same period; revenue was up double digits. A Bloomberg report last month found that customers are using Netflix fewer days each month than several years ago, and average viewing time per subscriber has declined.

Despite the deterioration in this key metric, I bought more Netflix shares a couple of weeks ago. With the stock trading close to the same level as the end of October, I think it's still a great opportunity for investors. Here's why I bought more.

Image source: Netflix.

The value proposition of Netflix

Netflix doesn't just compete with other premium streaming services; it competes with social media, podcasts, video games, YouTube, and tons of free entertainment. This is a dynamic that management has pointed out for years as an indication that it has a lot of room to grow.

Now, it appears that free entertainment has taken a bite out of its engagement. That's not necessarily a bad thing for the core subscription offering. Netflix is positioned as a premium product relative to free offerings like Alphabet's YouTube. It offers premium content like big-budget drama series and live events.

For a growing number of users, Netflix is becoming appointment viewing rather than something you put on after a long day at work when you don't have a plan to watch anything in particular.

Granted, it still serves as background entertainment for many people. There will always be room in Netflix's content budget for low-cost, high-volume productions. For example, it struck a deal with The Ringer to bring video podcasts to its platform.

Overall, however, the ability to keep customers subscribed comes down to offering must-have series and films. Customers appear happy with Netflix in that role. Management said its churn rate improved year over year in the third quarter despite pushing through price increases.

The advantage of Netflix's scale

Netflix's scale relative to other media companies is a huge advantage. It can spend more on content than anyone else because it can amortize that cost across a larger viewership. Netflix also has more data on how much its viewers actually value a particular piece of content, or how likely they are to value a new series or film. As a result, it can be extremely effective with its content budget.

With the vast majority of Netflix's revenue coming from subscriptions and subscriber growth being relatively predictable, management typically has a good idea of how much revenue it'll generate in a given year. It can then plan its largest expense, content, to achieve a target operating margin.

The result is steadily expanding operating margin, growing earnings, and strong free cash flow. Management returns that excess free cash flow to shareholders through share repurchases, helping produce strong earnings-per-share growth.

The continued operating leverage in the business remains very appealing, and there appears to be room to keep expanding operating margin over the coming years. That means even modest revenue growth, combined with the share repurchase plans, can result in very strong earnings-per-share growth.

But with investors worried about the company's user engagement, the stock price dropped to just 17.7 times forward earnings expectations. At that price, Netflix can see a further slowdown in revenue growth and still produce solid returns for investors.

Management doesn't expect revenue growth to slow much more than it has. CFO Spencer Neumann reiterated expectations for double-digit revenue growth, expanding profit margin, and growing free cash flow during the company's third-quarter earnings call. Achieving all of those makes the stock an excellent buy at the current price.

Adam Levy has positions in Alphabet and Netflix. The Motley Fool has positions in and recommends Alphabet and Netflix. The Motley Fool has a disclosure policy.