Netflix, Inc. (NFLX) reported $2.661 billion in Q1 free cash flow (FCF), a 24.5% YoY gain and up +93% over the prior quarter. Moreover, its FCF margin shot up to 25.2% from 15% in Q4, implying NFLX stock could be worth much more.

NFLX closed up 1.2% to $973.03, but the Thursday, April 17, earnings release came out after the close, and markets were not open on Friday, April 18. As a result, NFLX stock is poised to open 3.47% to $1,006.79 on Monday, April 20.

However, NFLX could be worth almost 17% at $1,176 per share more, given the huge increase in FCF margins that Netflix produced. This article will show why.

Free Cash Flow (FCF) Results

Netflix is one of the few technology companies that publishes its quarterly sequential operating and free cash flow (FCF) results. This can be seen in the table below from the first page of the Q1 shareholder letter (the FCF margin results are my analysis):

It shows that the most recent quarter had a massive jump in FCF margins  - from 13.5% in Q4 to 26.5% in Q1 and from 22.8% a year ago to 26.5%. This means that the company squeezed out much more free cash flow from its revenue.

And revenue only rose 12.5% YoY, so the 24.5% gain in YoY FCF (from $2.137 billion to $2.661 billion) was twice the gain in revenue. That is what operating leverage is all about. It means that a company's profitability scales exponentially as revenue rises. 

This is usually because after fixed costs are met, the marginal gain in revenue accrues proportionally larger to the bottom line. That implies huge increases in the company's future value.

For example, analysts now project that revenue for 2025 will rise to $44.31 billion this year (up from $39 billion last year) and $49.6 billion next year. In other words, its run rate revenue over the next 12 months (NTM) is about $46.96 billion.

So, if we apply an average FCF margin to this NTM revenue estimate, we can project its future FCF:

   $46.96 b x 26.5% FCF margin = $12.44 billion FCF (next 12 months)

FCF Yield Target Price

The market tends to give NFLX a valuation at a 2.4% FCF yield. For example, let's assume that the market believes its $2.661 billion Q1 FCF will repeat each quarter. That gives it a forward FCF estimate of $10.644 billion. As a result, here is how the market views its FCF yield:

  $10.644b / (437m shs x $1,006.79 open price) = $10.644b / $440b est. market cap = 0.2419 = 2.42% FCF yield

As a result, we can estimate the future NTM market cap for NFLX stock:

  $12.44b NTM FCF / 0.0242 = $514.05 billion target mkt cap

  $514b target / $440b mkt cap today = 1.168 = +16.8%

That implies that NFLX stock is still worth almost 17% more, or $1,175.93 (i.e., 1.168 x $1,006.79).

The bottom line is that if Netflix's revenue rises as analysts expect over the next two years, and it maintains an average 26.5% FCF margin, NFLX stock could still be undervalued.

Analysts Agree NFLX Is Undervalued

Yahoo! Finance reports that its survey of 48 analysts shows an average price target today of $1,076.24, and Barchart's survey is close at $1,077.77.

Moreover, AnaChart.com reports that its survey of 34 analysts is $1,037.35 per share. So, on average, these three surveys show a price target of $1,063.79, or +5.7% over the expected pending price on Monday, April 20.

However, many of these analysts are likely to raise their price targets, given the huge increase in FCF and FCF margins that Netflix produced.

As a result, analysts' upcoming recommendations could act as a further catalyst for NFLX stock as they roll out their new price targets.

One way to play this, for more conservative investors, is to set a lower buy-in target price. This can be done by selling short out-of-the-money (OTM) put options in nearby expiry periods.

Shorting OTM Puts

For example, the May 30 expiry period shows that the $965 strike price put contract closed with a midpoint premium of $56.20. This is likely to fall on opening on Monday, April 20. However, it shows that right now a short-seller of these puts can make an immediate yield of 5.82% (i.e., $56.20/$965.00).

The point is to watch for opportunities on the opening trades for options in NFLX stock. The out-of-the-money put (OTM) put options could offer some significant yield plays for observant investors.

For example, it might be possible to sell short the $990 put option on Monday, April 20, for the same $56.00 price as the $970 strike. That would still give an investor a potential yield play of 5.657% (i.e., $56/$990.00). 

Even a price of $40 or higher would be a great yield play (i.e., $40/$990 = 4.04%), as it would give the investor a low breakeven point (i.e., $990-40 = $950). That would be over 6% below the opening expected price of $1,006.79 on Monday.

In effect, this is a great way for existing NFLX investors to make extra income while they expect their holding in NFLX will appreciate.

The bottom line is that Netflix stock is poised to move higher based on its strong free cash flow (FCF) results, a FCF target price using an FCF yield valuation, and analysts' target prices. One way to play this for extra income is to sell short out-of-the-money (OTM) puts, especially for existing investors.

On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.