Five quarters ago, we took a chance on entering Netflix in 2022 based on two things:
1. The upcoming pivot to monetize through ads and by cutting off password sharing. In the June quarter of 2022, Netflix reported negative net additions QoQ. This quarter, Netflix reported some of the best growth in recent quarters. Notably, ads are not contributing meaningfully. Password sharing is helping the company drive growth in paid memberships both YoY and QoQ following the December quarter.
Per management: “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.”
2. Improved cash profile from negative (-$3.3B) in 2019 to a positive $1.6B in 2022. We had noted that management stated there would be substantial FCF growth in 2023. At the time, we had hoped for $3B to $4B in 2023. By raising FCF guidance every quarter this year, FCF will now come in at $6.5B. This is a phenomenal beat, although roughly $1 billion is from the Writer’s Strike. When adjusting for this, FCF is at $5.5 billion, which more realistically sets expectations for 2024 when content spend will be higher than 2023.
The weak spot in the report was average revenue per member, which declined (1%). Ideally, this improves with the price hikes the company announced today. This is reflected by a net paid addition beat that does not result in a revenue beat. With management guiding for similar net paid adds as Q3 (implying 9M) plus higher prices, the market is rewarding the stock because it’s assumed ARM will be higher next quarter. Netflix investors should continue to monitor lower ARM countries as time goes on as outsized growth here can potentially weigh on revenue growth. Last quarter, ARM was (-3%) and (-1%) on a CC basis.
Revenue and EPS:
- Netflix reported revenue of $8.5 billion in line with management guidance and analyst consensus. This represents growth of 7.8% and 8% on a constant currency basis (CC). This is an acceleration QoQ from the 2.7% growth and 6% on CC basis last quarter. However, this is not an acceleration from the year ago quarter on a CC basis, which grew 13%.
- Next quarter, Netflix guided in line for revenue of $8.7 billion for growth of 11% and 12% on CC basis. This will be an acceleration both QoQ (to be expected due to seasonality) and year-over-year with 10% growth on a CC basis in the year ago quarter.
- Overall, Netflix’s revenue growth is expected to trend upward over the next few quarters.
- The analyst consensus for adjusted EPS was $3.48 compared to $3.73 reported.
Operating Margin: A Bit of Confusion Following CFO Commentary Last Month
Analysts were expressing concerns going into this call about the FY2024 operating margin following a Bank of America conference when Spencer Neumann, CFO of the company, said:
“So I don't think given our scale now that we're at roughly 20% operating margins, I don't think it's really prudent for us to keep growing at 3 percentage points of margin per year. I think that would probably constrain the business too much on the growth opportunity. So, we'll grow margins more gradually. At some point, there's probably some peak margin where it's a good balance between peak margin and growth potential of the business. I just don't think we're anywhere near that yet. So we're going to gradually go into it.”I don't think it's really prudent for us to keep growing at 3 percentage points of margin per year. I think that would probably constrain the business too much on the growth opportunity. So, we'll grow margins more gradually. At some point, there's probably some peak margin where it's a good balance between peak margin and growth potential of the business. I just don't think we're anywhere near that yet. So we're going to gradually go into it.”
This caused analysts to scramble and lower their price targets as some had a 279 bps estimate for next quarter.
For example, published on September 28th: “JPMorgan lowered the firm's price target on Netflix to $455 from $505 and keeps an Overweight rating on the shares ahead of the Q3 report. The firm's overall view on Netflix shares remains positive, but it lowered estimates to reflect recent comments from management around margin expansion. Investor conversations suggest increased concerns that paid sharing is less impactful than expected and providing less lift in Q4, while 2024 margin expansion could be less robust than anticipated, the analyst tells investors in a research note.”
Here's another one from September 22nd:
“Oppenheimer lowered the firm's price target on Netflix to $470 from $515 and keeps an Outperform rating on the shares following the CFO's comments at a conference. The CFO said he was "not expecting future operating leverage of 300bps" going forward, and while the comments are likely not intended to be guidance, the firm took notice, given its prior view of 279bps improvement, the analyst tells investors in a research note.
There are quite a few like this. The interesting part is that Netflix actually guided operating margin for FY2024 growth of 200 bps to 300 bps, or 250 bps at the midpoint. Therefore, the comments may have been taken out of context to mean future years (?) as the guide was strong all things considered.
- Gross margin of 42.3% was in line
- Operating margin of 22.4% was in line. Management stated the FY2023 operating margin would be 20%, which was at the high end of previous guidance of 18% to 20%.
- Net profit of $1.68 billion was up 19.6%
- For full year 2024, management stated they are expecting full year operating margin of 22% to 23%.
Cash:
Netflix repurchased $2.5B in shares and increased the buyback authorization by $10B.
The company’s cash flow margins are a highlight of the report. Operating cash flow of $1.992 billion represents a cash flow margin of 23.3%. Free cash flow of $1.888B represents a FCF margin of 22.1%. This is up from a FCF margin of 6% in the year ago quarter. This is outsized due to the writer’s strike.
Overall, Netflix has substantial long-term debt and always will. We’ve covered this extensively in the past as their business model requires high content spend. The gross debt is $14 billion and the net debt is $6.5 billion.
Per management: “expect FCF of $6.5B up from $5B prior forecast. The company repurchased $2.5B shares in Q3 and increased buyback authorization by $10B. As a result, we expect 2023 cash content spend of around $13B and, assuming the SAG-AFTRA strike is resolved in the near future, we are currently expecting cash content spend of up to ~$17B in 2024.
As we said last quarter, the strikes will create some lumpiness in FCF over the 2023/2024 period, but we still plan to deliver very substantial positive FCF in 2024.”
Key Metrics:
Netflix reported 8.7M net paid adds for a total of 247.2 million paid memberships. This is the highest number of paid net adds in recent quarters. Analyst consensus was between 6.5M and 6.9M. Per management, this was due to: “the roll out of paid sharing, strong, steady programming and the ongoing expansion of streaming globally"
Across the regions, ARM in APAC had the biggest decline at (-9%). The United States region technically declined (Netflix reporting this as 0%) from $16.37 ARM a year ago to $16.29 ARM in the most recent quarter. All regions added paid net additions.
Across all regions, ARM was down (-1%). As stated, look for ARM to resume growth following the price hikes that were announced today.
Management stated that “ads plan membership is up 70% QoQ.” This is not meaningfully contributing to revenue. According to the Investor Letter: “It’s been less than a year since launch. It takes time to build a new business from scratch, which is why we have said ad revenue would not be material to our business in 2023.
Regarding engagement, Netflix had the most watched Series for 37 out of the first 38 weeks of the year. Share of screen time was 8% and second only to YouTube.
Earnings Call:
This was an important statement in terms of Netflix’s expectations for future revenue growth based on cutting off password sharing. I’m liking the word “incremental” here:
“So we're going to continue the rollout for the next couple of 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. We've seen that in the last couple of quarters. I think also worth noting that, that was on top of also very healthy organic, meaning not driven by paid sharing growth. So we anticipate seeing that for the next several quarters to come.”
There was a lot of discussion on the ads business, but the main takeaway is that the ads business has not taken off yet. However, management seems to think by 2024 it will begin to affect net paid adds and ARM:
“So I would say just generally, when we think about 2024 and beyond, think about it as our revenue growth profile in general. And we talked about this recently. We expect a more balanced mix of membership and ARM growth in 2024 and beyond 2024. So just looking at 2024 specifically, as Ted talked about, we expect to have a great slate to drive the business forward. And we expect to continue to do things like add extra members, grow our advertising revenue, as Greg discussed.”
Conclusion:
Netflix is exactly where we hoped it would be in terms of its product story and fundamentals. There has been ongoing uncertainty around whether the company would do well with the pivot. The writer’s strike and new management team has added to this uncertainty. This quarter helped provide the market with more visibility that the juggernaut is right on track. The only blemish in the report is ARM, which is being addressed in the upcoming pricing increases. We are very early in the earnings season, yet as more companies report, I think Netflix will stand out as company handling a challenging macro environment with ease.
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