🍿 Netflix: Advertising Economics
Ads show a promising start, and password sharing is dead (soon)
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Netflix (NFLX) reported its Q1 FY23 earnings earlier this week.
As the world's largest streaming platform, Netflix is a bellwether for the entertainment industry. So let's dive into the insights we've gleaned from the report.
Today, we’ll cover the following:
Netflix Q1 FY23.
Recent business highlights.
Key quotes from the earnings call.
What to watch looking forward.
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Greg Peters and Ted Sarandos officially began their tenure as co-CEOs.
Traditionally, Wall Street has considered total paid memberships as the primary indicator of the company's performance and execution.
Paid subscribers reached 232.5 million, with an increase of 1.75 million in Q1 FY23. Growth was driven by APAC (up 1.46 million) and EMEA (up 0.64 million), partially offset by a slight decline in LATAM (down 0.45 million).
Management had set a low bar, forecasting "modest positive paid net adds" for Q1 FY23. Following a strong holiday season, the first quarter is typically a weaker period for paid subscriber additions. This was especially true in LATAM, where Q4 FY22 saw a remarkable 1.76 million sub increase. As such, the slight sequential decline for the region was not surprising.
Subscriber additions are only half of the story, given the company's new focus on deepening monetization through a broader price range, an ad-supported plan, and the recent password-sharing crackdown (AKA “paid sharing”).
Management highlighted early successes in these areas, so let's look at the numbers to see how Netflix fared in Q1 amid intensifying competition.
1. Netflix Q1 FY23
Netflix is a straightforward business.
You get the revenue by multiplying two things:
👨👩👧👦 The number of paid memberships.
💵 The average revenue per membership (ARM).
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.
And now, its two recent initiatives — advertising and paid sharing — can potentially boost both memberships and ARM.
Q1 FY23 Memberships key metrics:
Total paid memberships grew +5% Y/Y to 232.5 million.
Net paid membership adds were +1.75M Q/Q (vs. “modest adds” expected).
Average Revenue per membership declined -1% Y/Y but grew +4% Y/Y on a constant currency basis (to $11.7/month).
Here is the bird’s-eye view of the income statement.
Some notes for context:
More than half of the revenue comes from outside the US and Canada (UCAN), creating significant currency headwinds for the business.
Cost of revenue is mainly comprised of the amortization of content assets. For example, that’s where Netflix amortizes producing and licensing streaming content costs. Here is a short accounting explanation from our previous article:
The cost of production of a show or movie is recognized as cost of revenue for Netflix when the show is made available for streaming on the platform. This is known as the "point of consumption.” The costs associated with producing a show, such as licensing fees, talent salaries, and production expenses, are capitalized on the balance sheet as a long-term asset, and amortized to cost of revenue over the estimated period the show will generate views. It’s called the “useful life” of the content.
Revenue grew +4% Y/Y to $8.16 billion ($20 million miss).
Revenue grew +8% Y/Y fx neutral.
Operating margin was 21% (1pp ahead of guidance).
EPS (earnings per share) was $2.88 ($0.01 beat).
Operating cash flow: $2.2 billion (27% margin, +15pp Y/Y).
Free cash flow: $2.1 billion (26% margin, +16pp Y/Y).
Cash and short-term investments: $7.8 billion.
Debt: $14.4 billion.
Q2 FY23 Guidance:
Revenue +3% Y/Y, or +6% Y/Y fx neutral.
Operating margin 19%.
Net membership addition expected to be roughly similar to Q1 FY23.
So what to make of all this?
Revenue grew by 8% on a currency-neutral basis (in line with guidance). To evaluate the long-term growth profile of the business, it's essential to examine revenue growth in this manner. Subscriber additions (up 5% Y/Y) and a continued rise in ARM (up 4% Y/Y fx neutral) contributed to this growth. Even with the launch of the cheaper ad-supported tier, the average monthly revenue per membership increased by +3% sequentially (from $11.3 to $11.7).
The operating margin was one percentage point ahead of guidance, primarily due to the timing of hiring. The margin was 21%, compared to 25% a year ago, mainly because of currency headwinds.
EPS met expectations and would have exceeded them without an $81 million currency-related loss (non-recurring).
Netflix remains on track to achieve its FY23 goal of an operating margin between 18% and 20% for FY23.
Q2 FY23 revenue guidance is set at a +6% Y/Y increase on a currency-neutral basis, with growth expected to re-accelerate in the second half of the year. Management anticipates "modest" positive paid net adds in Q2, resulting from the launch of paid sharing (more on that shortly).
Is the business sustainable?
With $1.6 billion generated in free cash flow in FY22 (5% margin), Netflix had already transitioned through the most cash-intensive part of its growth story (when it shifted to original content aggressively in 2014). The company has been cash-flow positive since 2020).
Management expects free cash flow to improve significantly in FY23 and reach $3.5 billion (an increase vs. the $3.0 billion forecast shared previously).
So the ~$6 billion net debt position on the balance sheet is less concerning than it looks at first glance. In our guide on how to analyze a balance sheet, we discussed how we want to see companies able to pay off their debt fast. While the balance sheet is not as robust as it could be, it’s expected to improve from here.
2. Recent business highlights
📀 The end of red envelopes
Netflix announced it’s officially exiting disc-mailing after 25 years:
"On September 29th, 2023, we will send out the last red envelope. It has been a true pleasure and honor to deliver movie nights to our wonderful members for 25 years. Thank you for being part of this incredible journey, including this final season of red envelopes."
The company will cancel remaining DVD subscriptions, while those signed up for both streaming and DVDs will switch to streaming-only.
Mailing DVDs with prepaid return envelopes disrupted companies like Blockbusters, but it had become a tiny part of the business (it was $30M or 0.4% of overall revenue in Q1 FY23).
📺 Advertising shows promising early signs
Netflix launched its ad-supported plan on November 3 at $6.99/month. The plan includes 5 minutes of advertising per hour.
From the shareholder letter:
“We are pleased with the current performance and trajectory of our per-member advertising economics. In the US for instance, our ads plan already has a total ARM (subscription + ads) greater than our standard plan. So this month we’ll upgrade the feature set of our ads plan to include 1080p versus 720p video quality and two concurrent streams in all 12 ads markets – starting with Canada and Spain today. We believe these enhancements will make our offering even more attractive to a broader set of consumers and further strengthen engagement for existing and new subscribers to the ads plan.”
This is important. Netflix already makes more money on its ad-supported plan (priced at $6.99/month in the U.S.) than its standard plan (priced at $15.49/month in the U.S.). So the thesis that management could unlock its ARM growth with ads is alive and well.
Management is doubling down and improving the experience to retain ad-supported users longer on the platform. If the company can improve its ARM while boosting its subscriber base, it could return to double-digit growth in the coming quarters.
🔒 Paid sharing is coming
Management estimated that over 100 million households use Netflix through shared account passwords.
Soon, Netflix will limit accounts to a single household, requiring members to pay extra if they wish to share their account with people outside their residence.
This change may initially impact engagement metrics, as many "borrowers" could lose access and might not convert to paid subscribers. However, the long-term effect is anticipated to be positive, increasing subscriptions.
To recap, the new rules will be:
One household per account.
Option to add additional households for $2.99 each.
Travel access is included via tablet, laptop, or mobile.
The paid sharing feature has been in beta in five Latin American countries (and Canada recently) and is expected to roll out in Q2 FY23. Management believes this feature will significantly alter the pattern of new paid subscriptions. Based on the beta period, they foresee short-term challenges but long-term benefits.
Co-CEO Greg Peters discussed password sharing on the call:
“This last of the country rollouts have gone well, and maybe most important, were directionally consistent with what we saw in Latin America. Very much like a price increase. You see an initial cancel reaction. And then we build out of that both in terms of membership and revenue as borrowers sign up for their own Netflix accounts. And existing members purchase that extra member facility for folks that they want to share with.”
On the delay of the paid-sharing rollout (initially planned in Q1):
"It was better to take a little bit of extra time, incorporate those learnings and make this transition as smooth as possible [...] And we think that approach also best serves the long-term business goals as well."
🕹️ Netflix games coming to TV?
Netflix is reportedly working on bringing games to TV, with the iPhone as a controller.
This move is not entirely unexpected. Netflix, known for its focus on digital distribution and lean organizational structure, is unlikely to venture into hardware. Instead, the company's gaming strategy aims for low friction and easy access for existing subscribers. Currently, Netflix games are free and available on a platform you already own: your phone.
Using the iPhone as a controller for casual games on TV is a logical next step. What began as a mobile-first strategy could rapidly evolve into a multi-platform initiative. Moreover, Netflix recently posted a job listing for a game director to work on a high-budget AAA PC game.
Given the growing advertising segment, it wouldn't be surprising to see ad placements within games for the ad-supported plan.
🎥 Live streaming not ready for prime time
Netflix recently hosted its second live-stream media event, featuring a reunion for the popular dating show 'Love Is Blind.' Unfortunately, fans experienced over an hour of delay on Sunday night.
Co-CEO Greg Peters explained:
“We just didn’t see this bug in internal testing because it only became apparent once we put multiple systems interacting with each other under the load of millions of people trying to watch Love Is Blind.”
Despite the hiccup, Netflix still managed to draw 6.5 million viewers for the special. The streaming giant is likely to explore more live events, considering its growing focus on advertising (though live sports seem unlikely, based on past interviews with Reed Hastings and Ted Sarandon).
3. Key quotes from the earnings call
Greg Peters on advertising:
"We've got a lot of work to do to continue to develop product features that support advertisers. We're rolling out things like measurement and verification, but we've got a bigger, longer, longer roadmap that we have to go through there. We're improving our go-to-market and sales capabilities in partnership with Microsoft."
CFO Spencer Neumann said on the ad-supported plan:
"We're pleased with our per-member ad plan economics. In the U.S., it's actually been higher than our standard plan [...] It's kind of a win-win because it's a lower-priced option for our members, and [...] it's incremental revenue, incremental profits to the business."
On capital allocation, VP of Finance Spencer Wang said:
“We're still targeting to maintain minimum cash equivalent to roughly two months of revenue. [….] share repurchases will accelerate over the course of the year"
Based on their target, Netflix has about $2.4 billion in excess cash to put to work, so we can expect more cash to be returned to shareholders in the coming quarters. Management bought back $400 million in Q1 FY23.
Ted Sarandon on a potential writer’s strike looming :
"If there is [a strike], we have a large base of upcoming shows and films from around the world. We could probably serve our members better than most. We really don't want this to happen. But we have to make plans for the worst. And so we do have a pretty robust slate of releases for [...] a long time."
Following a question on the film distribution strategy, he added:
“Driving folks to a theater is just not our business. We create that demand. We collect that demand on our subscription service with our members. And I think having big new desirable content, including feature films in the first window drives value for our members and drives value to the business. So no major changes in play, except for trying to continue to improve the films for our members and make a big splash with films that are loved and watched.”
Netflix prefers to bypass theatrical releases, focusing instead on drawing attention to its digital service. This approach aligns with the notion that a subscriber's lifetime value far exceeds the profit from a single ticket sale at the theater. Boasting a substantial user base, the platform can create a buzz around its movie releases without relying on traditional big-screen debuts.
4. What to watch looking forward
A long runway riding the streaming wave
Nielsen, a market measurement firm, provides monthly data on US TV Time. They recently adjusted their methodology, moving YouTube TV and Hulu Live from the streaming category to the "other" category. This change was applied to data from July 2022 onwards, which may cause streaming to appear as a smaller share than previously reported.
YouTube TV and Hulu Live are virtual multichannel video programming distributors, or "vMVPDs." These services resemble the cable model by bundling numerous channels, including live sports.
According to Nielsen, streaming accounted for 34.1% of US TV Time in March 2023, representing an 8 percentage point increase year-over-year
Netflix alone was 7.3% of US TV time in March (+0.7 percentage points Y/Y).
While Netflix has lost market share to YouTube, it has maintained an impressive lead over other streaming rivals like Hulu, Prime Video, Disney+, and HBO Max.
The chart above indicates that the overall streaming market is expanding. Thus, if Netflix maintains its market share, it could still experience steady growth.
Unlike legacy players such as Disney and Warner Brothers, who are transitioning revenue from linear to streaming, Netflix solely reaps the benefits of the shift to streaming without any drawbacks.
Based on recent market reports from Nielsen, Kantar, and BARB, Netflix is still:
Less than 10% of TV time in the US and the UK, its most important markets.
Less than 5% of TV time in Mexico, Brazil, and Poland.
As illustrated in the chart below, streaming still has a low penetration, particularly in LATAM.
In addition, the APAC market remains largely untapped, with only 39 million Netflix subscribers at the end of Q1 2023.
Still dominating the charts
Netflix is widely recognized for its impressively low churn rate (and, consequently, better retention) within the industry. In 2022, Antenna estimated Netflix's monthly churn rate at 3.3%, significantly below the 5% average for premium SVOD services.
One possible factor is the absence of live sports content. Companies with a robust back catalog will likely succeed in the long run. While live sports can effectively attract new subscribers, the content becomes outdated the moment the game ends. In contrast, evergreen content has the potential to work wonders for customer retention.
In 2022, Stanger Things 4 and Wednesday surpassed 1 billion hours viewed.
During Q1 2023, Netflix saw great success with shows such as You, Shadow and Bone, and Outer Banks, which topped the charts for several weeks.
Many observers fail to recognize the magnitude of these hits. But ultimately, it's the users who determine what is binge-worthy. Notably, the recent release of The Night Agent has become the 6th most popular English language TV show of all time on Netflix, outperforming The Witcher and Stranger Things 3 in its first 28 days.
Netflix excels at promoting its content primarily on the platform itself. Once a new show or movie becomes available, the streaming service employs various methods to grab viewers' attention. These include featuring a large trailer on the app's home screen, sending release announcements via email, and using personalized recommendations based on viewing history.
With its extensive reach of nearly 233 million subscribers, Netflix can transform a new release into a pop culture phenomenon, consistently capturing the zeitgeist. A recent example is the TV show Beef, which has become a personal favorite.
Stay tuned for updates on other streaming giants in the coming weeks. 🍿🎬
That’s it for today!
Stay healthy and invest on!
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.