🍿 Netflix: Ads are coming
And why the binge release format continues to thrive.
Hello there! 👋
Greetings from San Francisco!
On Tuesday, Netflix (NFLX) reported its Q3 FY22 earnings.
Today, we’ll cover the following:
If you are only interested in the earnings, you can skip to that section.
I want first to address the rollercoaster Netflix has been for shareholders in 2022.
The stock collapsed more than 70% from its 2021 high in April.
Billionaire investor and hedge fund manager Bill Ackman did a full 180 earlier this year. First, he became one of the largest Netflix shareholders in January 2022.
However, following a disappointing Q1 FY22, Ackman decided to ditch his shares after just three months, losing $400M in the process.
Here is what he shared with Pershing Square investors at the time:
We require a high degree of predictability in the businesses in which we invest due to the highly concentrated nature of our portfolio. While Netflix’s business is fundamentally simple to understand, in light of recent events, we have lost confidence in our ability to predict the company’s future prospects with a sufficient degree of certainty. Based on management’s track record, we would not be surprised to see Netflix continue to be a highly successful company and an excellent investment from its current market value. That said, we believe the dispersion of outcomes has widened to a sufficiently large extent that it is challenging for the company to meet our requirements for a core holding.
In short, the lack of clarity on future paid member adds was in conflict with the size of the position. To be sure, we all have to wrestle with this idea.
I avoid this problem by always starting with a small position (sub-2% allocation). I would have no problem letting a position become very large over time, but it’ll have to get there through its sheer performance, not because I bet the farm from the start. I buy more of an existing position only when I see more evidence of success.
As a result, I rarely have a position so big that “uncertainty” is a reason to sell. In addition, I don’t believe a widening range of outcomes is necessarily sufficient to sell a high-quality business.
Success is not linear. Virtually all holdings in a portfolio will face uncertainty at some point. Selling in the face of uncertainty is like a stop-loss order. It’s a guaranteed sell order at the worst possible time. It might be helpful for a trader. But for a long-term investor? Not so much.
So what caused this great uncertainty in the first half?
In Q1 FY22: Netflix reported a net loss of 0.2 million subscribers (vs. expectations of a gain of 2.5 million). The suspension of the service in Russia (0.7 million lost subscribers) was partially to blame. But even excluding Russia, management missed the mark by 2.0 million subs.
In Q2 FY22: Netflix lost another 1.0 million subscribers (vs. expectations of a loss of 1.5 to 2.0 million). Management had set expectations very low.
So we were looking at a net loss of 1.2 million subscribers in the first half of 2022. And management provided a relatively soft forecast of 1.0 million paid net adds for Q3.
So, what happened?
Let’s dive in!
1. Netflix Q3 FY22
Netflix is a straightforward business.
You get the revenue by multiplying two things:
The number of paid memberships.
The average revenue per membership.
Here are the US plans:
Basic with ads (more on that later): $6.99/month.
Basic: $9.99/month (1 device at a time, HD).
Standard: $15.49/month (2 devices at a time, Full HD).
Premium: $19.99/month (4 devices at a time, Ultra HD).
Netflix has raised its price regularly over the years (most recently in January 2022). While a price hike can temporarily increase churn, it’s usually short-lived. That’s why Netflix is celebrated for its pricing power.
Q3 FY22 Memberships key metrics:
Total paid memberships grew +5% Y/Y to 223M.
Net paid memberships were +2.4M Q/Q (vs. +1.0M guidance).
Average revenue per membership rose +1% Y/Y (vs. +2% Y/Y in Q2 FY22). It would have been +8% Y/Y in constant currency.
Here is the bird’s-eye view of the income statement.
Data source: Shareholder letter.
More than half of the revenue comes from outside the US and Canada (UCAN).
Cost of revenue is mostly comprised of the amortization of content assets. That’s where Netflix amortizes the cost of producing and licensing streaming content.
Q3 FY22 Financials:
Revenue grew +6% Y/Y to $7.9B (vs. +5% Y/Y guidance).
Operating margin was 19% (vs. 16% guidance).
Operating cash flow margin was 7%.
Balance sheet: Cash: $6.1B. Long-term debt: $13.9B.
Q4 FY22 Guidance:
Revenue growth +1% Y/Y.
Operating margin 4%.
Net membership addition +4.5M.
Let’s unpack a few things.
Management crushed their Q3 guidance, adding 2.4 million paid memberships. It was driven by the Asia-Pacific region (+1.4 million).
With more than half of revenue coming from outside of North America, the strong dollar created a significant headwind of 7 percentage points.
The strong dollar is great news if you are on vacation in Italy. But it’s a drag if you’re a US company with international revenue converted back to US dollars. Yet, revenue growth and operating margin were ahead of guidance.
Revenue grew +13% Y/Y fx neutral, which is the best indication of the company's long-term growth profile.
Operating profit was better than expected, partially explained by some expenses that shifted to Q4 FY22.
Now let’s turn to the Q4 guidance provided:
Net paid adds: Q4 is seasonally the strongest quarter for new subscribers. The guidance did not disappoint with an expected 4.5M paid net adds.
Revenue growth: Management mentioned a $0.8B fx revenue headwind, so Q4 revenue guidance is approximately +11% Y/Y fx neutral.
Operating margin: Q4 is seasonally the weakest quarter due to higher marketing spending. While the strong dollar adversely impacts revenue, most costs are in dollars and remain the same. So the margins will suffer temporarily. Hence the 4% operating margin guidance.
Is the business sustainable?
For one thing, it’s highly profitable, with a 20% operating margin in the past year.
When Netflix shifted its strategy to original content in 2014, the company had an awful cash flow margin profile. It spent billions of dollars annually to create original content and beef up its catalog.
The business has already transitioned through the most cash-intensive part of its growth story (the company has been cash-flow positive since 2020).
Management continues to forecast +$1B in free cash flow in FY22 and expects annual positive FCF moving forward.
2. Recent business highlights.
Two areas will shape the near term.
First, the main one: Advertising.
Netflix will launch an ad-supported plan on November 3 at $6.99/month.
The ad-supported plan will have ”5 minutes of advertising per hour, frequency capping & strong privacy protection.”
Management is optimistic about this tier but expects minimal contribution in the Q4 FY22 guidance. This approach is known as “underpromise and overdeliver.”
There are several reasons to be optimistic.
The new low price is a lower barrier to entry that could bring new (and stickier?) subscribers (though it could cannibalize the Basic plan).
Netflix has floated ad prices of $65 per thousand impressions (CPM). It’s a relatively high rate by industry standards. Connected TV advertising rates ($35 to $65) are higher than linear TV ($10 to $15). But that still leaves Netflix on the high end of the spectrum.
Second: Paid sharing.
I have bad news if you’ve been using your parents’ Netflix password. Netflix is cracking down on password sharing.
A new “add a home” feature is in beta in five LATAM counties and will give the option to buy additional homes for $2.99.
3. Key quotes from the earnings call
It’s hard not to look at Netflix as a remarkable growth story if you zoom out.
Co-CEO & Chief Content Officer Ted Sarandos explained:
“We started this about 10 years ago. We had no IP. We had no library. We moved as quickly as we could to build a library of our own IP […] that library now gets more viewing, more revenue, and more profit than all of our competitors who've been at it for over 100 years.”
CFO Spencer Wang was optimistic about the long-term impact of ads:
“We feel good that this will be kind of net neutral to positive out of the gate and then when you add in the incrementality on subscribers we think we can build a big incremental revenue and profit stream.”
4. What to watch looking forward
Starting next quarter, management won’t forecast net paid memberships. Instead, revenue will be a better metric with the addition of the ad-supported tier and paid sharing.
Engagement will become an increasingly critical factor. Revenue growth could outpace net membership addition through ads and paid sharing.
Historically, Netflix has been the engagement king. Management defends its binge-release model as a critical part of its “significant long-term business advantage.”
According to Google Trends, the limited Netflix series Dahmer generated more hype in September than The Rings of Power (Prime Video) and House Of The Dragon (HBO Max) combined. Having all episodes released at once was likely a factor.
According to Nielsen, streaming represented 36.9% of US TV Time in September 2022 (+9.2pp Y/Y). Netflix reached 7.3% of US TV time in September (+0.8pp Y/Y).
While Netflix is losing to YouTube, it’s still gaining more engagement than its other largest competitors (Hulu, Prime Video, Disney+, and HBO Max).
The chart above shows the overall streaming pie is growing. There can be many winners in a secular trend like streaming and connected TVs.
But there is a catch!
For example, a company like Disney suffers from creative destruction, shifting revenue from linear to streaming. Meanwhile, Netflix only benefits from the shift to streaming, with no drawback.
As long as Netflix continues to win the engagement war, the company is poised to succeed. According to the recent market data, so far, so good.
Before you go, here is a little bonus.
Knives Out 2 will benefit from a limited release in theaters for Thanksgiving.
For theatrical releases, Netflix wanted a symphonic version of their iconic “ta-dum” sound. So, they called Hans Zimmer (film score composer for The Lion King, Gladiator, The Dark Knight Trilogy, Inception, and Interstellar, to name a few).
The result is fantastic. Sound on! 🔈
That’s it for today!
Stay healthy and invest on!
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Disclosure: I am long NFLX in the App Economy Portfolio. I share my NFLX rating (BUY, SELL or HOLD) with App Economy Portfolio members here.