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🍿 The Rise of the House of Netflix
From horror hits to strong earnings, Netflix serves up a thrilling October
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🎃 As October's chill descends and Halloween lurks around the corner, Netflix's horror hit, The Fall of The House Of Usher, is captivating audiences worldwide.
But it isn't just fictional houses that are drawing attention. The streaming giant just delivered another blockbuster quarter. As Edgar Allan Poe's iconic House of Usher crumbles, we see Netflix's own house rise.
As a treat, the company recently unveiled plans for 'Netflix House,' its first permanent fan experience location, set to open its doors in 2025.
Today at a glance:
Netflix Q3 FY23 overview.
Recent business highlights.
Key quotes from the earnings call.
What to watch looking forward.
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1. Netflix Q3 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).
The story of the year for Netflix has been its password-sharing crackdown — now officially known as "paid sharing." While many observers warned it could backfire and management anticipated some membership attrition initially, the opposite is happening.
Netflix ended Q3 FY23 with:
247 million paid memberships.
Adding nearly 9 million during the quarter (vs. ~6 million expected).
It’s the best quarter in membership adds since early 2020 (boosted by the pandemic).
Growth was most notable in the EMEA region (+14% Y/Y) and the APAC region (+17% Y/Y). All regions reported the addition of over 1 million subscribers during the quarter.
Paid sharing was introduced in the US and parts of EMEA in May to prevent the widespread practice of sharing Netflix account passwords between non-household members. This initiative is now officially a resounding success.
Paid sharing wasn’t the only factor, to be sure. The content slate continued to improve with popular shows like One Piece and The Witcher.
With many variables, such as paid sharing and advertising, revenue growth is now a better performance indicator than paid membership. ARM was down 1% Y/Y, partially explained by a higher growth from lower ARM countries. Netflix has raised its price regularly over time, but not since January 2022.
Here is the bird’s-eye view of the income statement.
Revenue grew +8% Y/Y to $8.5 billion.
Operating margin was 22% (+3pp Y/Y).
EPS (earnings per share) was $3.73 ($0.23 beat).
Operating cash flow: $2.0 billion (23% margin, +16pp Y/Y).
Free cash flow: $1.9 billion (22% margin, +16pp Y/Y).
Cash and short-term investments: $7.9 billion.
Debt: $14.3 billion.
Q4 FY23 Guidance:
Revenue +11% Y/Y (or +12% Y/Y in constant currency).
Operating margin 13% (+6pp Y/Y).
Net membership additions are expected to be roughly similar to Q3 FY23.
So what to make of all this?
Revenue grew by 8%, slightly ahead of guidance. This growth was fueled by the strong paid membership additions, marginally offset by the lower ARM.
Netflix's guidance for Q4 FY23 shows more acceleration, with a forecasted 11% Y/Y revenue increase and similar membership additions as Q3. This indicates another impressive quarter is in the pipeline.
The operating margin was better than expected at 22% compared to last year's 19%. This improvement was primarily due to the revenue upside and the timing of some spending. It also demonstrates Netflix's operating leverage—its ability to grow revenue faster than expenses.
Netflix now expects a 20% operating margin in FY23, on the high end of its 18% to 20% target.
FY24 operating margin guidance is 22% to 23%, implying more margin expansion. Netflix has a very scalable business model with no near-term margin ceiling.
The free cash flow estimate for FY23 is now $6.5 billion. This is another major update following the previous raise from $3.5 to $5.0 billion in Q2 FY23. The ongoing Hollywood strikes contributed to lower cash content spend by about $1 billion. The end of the strike could create some lumpiness in free cash flow in FY24 (more on this in a minute).
Management authorized an additional stock buyback of $10 billion. And they repurchased $2.5 billion in Q3.
Is the business sustainable?
With $6 billion in free cash flow expected in FY23, Netflix has 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).
Netflix’s recent free cash flow increase is noteworthy when considering other legacy entertainment companies. We’ll update this chart when other earnings trickle in.
So, the ~$6.5 billion net debt position on the balance sheet isn’t too concerning. In our guide on how to analyze a balance sheet, we discussed how to put a company’s debt in context with other financial statements.
2. Recent business highlights
🔒 Paid sharing is working
Management estimated that over 100 million households used Netflix through shared account passwords. They are well on their way to prove their point.
As a reminder, the new rules are:
One household per account.
Option to add additional households for $2.99 each.
Travel access is included via tablet, laptop, or mobile.
On the one hand, password borrowers have lost access, leading to less engagement on the platform. Conversely, paid sharing is leading to an increase in memberships.
From the shareholder letter:
“The cancel reaction continues to be low, exceeding our expectations, and borrower households converting into full paying memberships are demonstrating healthy retention. As a result, we’re revenue positive in every region when accounting for additional spin off accounts and extra members, churn and changes to our plan mix. Going forward, we’ll continue to refine and optimize our approach to convert additional borrower households into either full paying members or extra members over the next several quarters.”
Antenna has been tracking US Premium gross additions across SVOD services (Service Video On Demand) and confirms this trend:
June spike: In June, Netflix saw a spike of 3.5 million gross adds — the largest month ever measured for the service — representing 24% of all gross adds in the SVOD market.
Normalizing, but still high: Since then, the trend has normalized, with 2.1M gross adds in September, or 15% of the SVOD market. It remains higher than the 8%-to-13% range before the password crackdown.
Overall, Antenna’s estimates match the numbers management shared in the earnings call. Netflix claimed a 17% market share of US Premium SVOD gross adds in Q3 (compared to 16% in Q2).
💰 New price hike
Every few quarters, when there is enough evidence that churn is stable, Netflix has steadily hiked its monthly price. While it can temporarily increase churn, the negative reaction tends to be short-lived.
While management focused on paid sharing, there have been no hikes since early 2022. Now, the company is adjusting its price in big markets.
For example, in the US:
Basic will increase to $11.99 (from $9.99).
Premium will increase to $22.99 (from $19.99).
Other plans remain the same.
Through these price hikes, it's clear that Netflix is making its ad-supported plan ($6.99) a more compelling offer for new members. It’s by design. The ad plan requires sufficient reach to appeal to advertisers. YouTube has demonstrated success in this area, and Netflix could follow suit.
📺 The ad-supported tier expands its reach
Management shared that ads plan membership grew nearly 70% quarter-over-quarter and represented 30% of new sign-ups.
Antenna estimated a similar number, with 30% of Netflix sign-ups coming from the Standard with ads in September. Disney+ and Paramount+ have more mature ad plans and see comparable success with their ad plans. Note that the Basic tier ($9.99/month ine US) is gone for new customers in select countries, including the US and Canada, which was a positive factor boosting the ad-supported pan.
Netflix launched its ad-supported plan on November 3, with 5 minutes of advertising per hour. As discussed last quarter, Netflix's ad-supported plan (priced at $6.99/month in the US) generates more revenue than its standard plan (priced at $15.49/month in the US), thanks to ad revenue more than compensating for the lower price.
Management is making it more attractive for subscribers to opt for the ad-supported plan and for brands to be on Netflix. For management, scale is the top priority to offer advertisers a competitive product.
3. Key quotes from the earnings call
Co-CEO Greg Peters on paid sharing:
“I think paid sharing represents the kind of difficult challenge where we need to balance both important relevant consumer considerations with the importance of ensuring that our business got reasonably paid when we deliver entertainment.“
If there were 100 million borrowers before May 2023, it’s safe to say there could be a lot more upside coming from this initiative beyond the 15 million net adds in the past two quarters.
“I think folks are trying to figure out how much juice is left there. And I would say we anticipate that we will have incremental acquisition, incremental adds for the next several quarters.”
On the importance of scale for the ad business:
"On a per-country basis, think about this as essentially a percentage of market penetration that helps us focus and drive the rate of growth that we desire. And we've got more work to do to get that something [...] we're not satisfied with the scale that we're at, in any country that we're in: We want to be bigger, we know we can be bigger."
With 30% of new sign-ups opting for the ad-supported tier, the initiative is on the right track. It’s just a matter of time.
On the advertising opportunity:
"This is a $180 billion opportunity when you think about linear TV, you think about connected TV, not including YouTube, not including China and Russia. And we think we're in a great position to win some of those dollars.”
Netflix appointed Amy Reinhard to lead the ad division. She was previously VP of studio operations and was able to drive strong growth for the business in her previous role.
“Our job is to incrementally scale to the place where games have a material impact on the business. We've got ambitious plans there. We want to really grow our engagement by many multiples of where it is today over the next handful of years.”
Gaming is still an early venture, but we have not seen a killer app in this category yet.
Co-CEO Ted Sarando on live events:
“We are in the sports business, but we're in the part of the sports business that we bring the most value to, which is the drama of sport.“
From Formula 1: Drive to Survive to events like The Netflix Cup that will partner with sports celebrities for a match-play golf tournament, Netflix shows that there is another way to win in sports content.
By the way, the new David Beckham documentary is a must-watch for those seeking a nostalgic trip back to the '90s.
On the Hollywood strike:
"We want nothing more than to resolve this and get everyone back to work. […] The Guild presented this new demand [...] for a per-subscriber levy, unrelated to viewing or success and this really broke our momentum. […] We need to get a deal done that respects all sides as soon as we possibly can.”
While the Hollywood strike does not impact a vast pool of Netflix content, the faster they can reach a deal, the better for all participants. Spending is expected to ramp up to $17 billion annually once the trike resolves, after dropping to $13 billion recently.
4. What to watch looking forward
🪧 Hollywood writers end their strike, but not actors
After nearly five months, the Writers Guild of America (WGA) ended its strike in September. Writers have been given the go-ahead to resume work.
Writers’ Key Agreement Terms:
Compensation & Benefits: Increases overall compensation, pension, and health fund rates.
Employment Terms: Improved length of employment conditions and writing team sizes.
Residuals: Better residuals (royalties for reruns, streaming, and other subsequent releases), including those from foreign streaming.
AI in Writing: Restrictions on AI usage, ensuring writers aren't replaced or have their pay reduced. Specifically, companies can't mandate writers to use AI, but writers can choose to use AI tools with company consent.
Now, the attention shifts to the Screen Actors Guild-American Federation of Television and Radio Artists (SAG-AFTRA).
Actors’ Key Holdouts:
Still ongoing: The actors remain on strike, and most productions can't proceed until it ends.
Historical context: Typically, the WGA's agreement influences the agreements of Hollywood's other trade unions.
Current negotiations gaps: The gap between major studios and SG-AFTRA is currently “too great” to continue negotiations.
Residuals: Actors want to receive new streaming residuals that would cost the studios approximately $0.5 billion.
Other issues: From AI to minimum rates, other topics remain unresolved. But residuals are currently the crux of the negotiations.
🏠 ‘Netflix House’ is coming
Netflix's first permanent retail sites will launch in 2025, immersing fans in their favorite TV show worlds. It will be the company’s most significant investment in the physical fan experience.
Offerings: A mix of shopping, themed dining, and live experiences. It will include rotating installations inspired by popular Netflix series.
Expansion: Starting in the US, with plans for global roll-out.
Previous ventures: Netflix has tried 40 pop-up experiences globally, such as "The Queen’s Ball: A Bridgerton Experience" and a themed pop-up restaurant in Los Angeles.
At the Bloomberg Screentime conference, Co-CEO Ted Sarandos said:
“Don’t think of it like Disneyland […] (It’s) something you might go to a couple times a month, not just once every couple years.”
These retail sites aim to promote titles and cultivate fan communities rather than generate a profit.
👑 Engagement is queen
I always like to say that the user is king, but engagement is queen (a lesson from my years in the gaming industry). Strong user engagement bleeds into metrics like retention (with users committed to ongoing shows) and acquisition (via word of mouth).
An excellent proxy for engagement is Nielsen’s monthly market measurement. Netflix represented 8% of TV time in September, only behind YouTube in the streaming category, and more than 2X the market share of the closest competitors (Prime Video and Hulu).
According to Nielsen, streaming accounted for 37.5% of US TV Time in September 2023, representing a six percentage point increase compared to September 2022.
While Netflix has lost market share to YouTube, it has maintained an impressive lead over other streaming rivals like Hulu, Prime Video, Disney+, and Max. The chart below 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, who are transitioning revenue from linear to streaming, Netflix solely reaps the benefits of the shift to streaming without any drawbacks.
📊 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.
With its extensive reach of over 247 million subscribers, Netflix can transform a new release into a pop culture phenomenon, consistently capturing the zeitgeist.
Last quarter, I mentioned that all nine seasons of the legal drama Suits—a show that ended four years ago—were released on Netflix in a renewed licensing deal in the US. It instantly became the most-watched TV content in the US by a mile. And believe it or not, Suits stayed number one in the US for 12 consecutive weeks, setting a streaming chart record. It was only dethroned in September by another Netflix show (a new season of Virgin River).
Suits generated 1 billion view hours on Netflix, prompting management to highlight the potential for future licensing deals to complement the original programming.
An interesting detail is that Meghan Markle (later Duchess of Sussex) was one of the characters in Suits. Netflix changes thumbnails based on individual accounts, so it’s possible Meghan Markle was showcased to those who watch content related to the royal family.
This is further evidence that Netflix excels at promoting its content primarily on the platform itself. Once a new show becomes available, Netflix 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 and custom thumbnails based on viewing history.
While new members are behind the growth in 2023, the know-how to engage and delight users will be the growth engine in 2024 and beyond.
Stay tuned for more updates on other streaming giants in the coming weeks. 🍿
That’s it for today!
Stay healthy and invest on!
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Author's Note (Bertrand here 👋🏼): The views and opinions expressed in this newsletter are solely my own and should not be considered financial advice or any other organization's views.
Disclosure: I am long NFLX in the App Economy Portfolio, where I share my NFLX rating (BUY, SELL, or HOLD) with members.