Please note, we will be writing up pre-earnings notes on the forum for the stocks we own. You can access Netflix’s pre-ER here.
Highlights:
- No major flags in the earnings report
- For Q3, the company beat on subscribers, revenue, operating margin and free cash flow
- Q4 guide is in-line across the board. Next quarter will see lower operating margin due to seasonality
- The new ad supported tier rolls out in two weeks; we believe this is an underappreciated catalyst. The ad supported tier will monetize at the same rate or even higher than legacy tiers with $6.99 monthly subscription combined with $10 ARPU over time (needs time to ramp to reach this ARPU).
- High probability of revenue acceleration from ad tier combined with improved cash profile combines for an attractive stock for 2023. Not only will Q4 and Q1 provide some clues around the new trajectory but we will also keep an eye on the upfront season in April/May.
- The company is still trading well below its 5-year historic valuation
Financials:
Netflix had a sizable beat on subscribers and the stock is breathing a visible sigh of relief as the company comfortably beat with 2.4M net adds compared to 1M to 1.2M expected. Consensus for next quarter was 4.1M with Netflix guiding for 4.5M.
The largest contributor to growth is the APAC region at 1.4M new subs followed by EMEA at 0.6M subs and LatAm at 0.3M subs. United States and Canada reported 0.1M subs whereas in the past this region saw churn.
Revenue was up 5.9% compared to 4.7% expected. On a constant currency basis, revenue grew 13% YoY. There is a miss on revenue for next quarter due to FX headwinds. The company guided for 1% growth versus 3.5% growth expected. On a constant currency, Q4 is expected to grow 9%. This creates a slight miss on FY2022 revenue at $31.5 billion guided versus $31.6 billion expected. As was the case last quarter, the market is willing to overlook FX headwinds.
As we’ve covered in the past, I continue to believe revenue growth is too low for the upcoming ad tier and the roll-out of how to phase out password sharing.
Here was the update from Netflix regarding the new ad-supported tier from the Investor’s Note:
“As we’ve been discussing over the past few quarters, improving our pricing strategy is an important near-term focus. Last week, we announced that we’ll be launching an ad-supported subscription plan on November 1 in Canada and Mexico; November 3 in Australia, Brazil, France, Germany, Italy, Japan, Korea, the UK, and the US; and November 10 in Spain. Cumulatively, these 12 markets account for ~$140 billion of brand advertising spend across TV and streaming, or over 75% of the global market.
To start, we’re keeping it simple by offering one low-priced ad plan – Basic with Ads – at a price that’s 20%-40% below our current starting price. So in the US, for example, Netflix will now start at $6.99 per month (compared to $9.99 today). The Basic with Ads plan will have ~5 minutes of advertising per hour, frequency capping and strong privacy protections.”
Per our Pre-ER notes, analysts are expecting $10 ARPU from the 5 minutes of advertising when it’s fully rolled out, which puts this tier on par with other tiers for revenue growth.
Password sharing is being leveraged by 100 million viewers. Here was Netflix’s update on how they plan to monetize these users:
“Finally, we’ve landed on a thoughtful approach to monetize account sharing and we’ll begin rolling this out more broadly starting in early 2023. After listening to consumer feedback, we are going to offer the ability for borrowers to transfer their Netflix profile into their own account, and for sharers to manage their devices more easily and to create sub-accounts (“extra member”), if they want to pay for family or friends. In countries with our lower-priced ad-supported plan, we expect the profile transfer option for borrowers to be especially popular.”
Operating margin came in higher than expected at 19% versus management’s previous guidance of 16%. There was a 4% decline from the previous year due to FX. The company is guiding for an operating margin of 4% to 8% next quarter, or 10% on a constant currency (CC) basis. This is due to seasonal spending on marketing and content, and on a CC basis, will be higher than last year’s 8.20%.
The revenue and operating margin beats flowed through to a net income beat of $1.39B compared to $961M expected. Operating cash flow was at $557 million and free cash flow came in at $472 million. This means management has made good on its promise to see $1 billion FCF this year. It also implies FCF could be ($287) million next quarter as we are at $1.287 billion for the year.
For our position, this being reiterated regarding FCF next year is key: “We continue to expect FCF of +$1 billion for the full year 2022, plus or minus a few hundred million dollars and substantial growth in FCF in 2023 (assuming no further material appreciation of the US dollar).”
There was a minor improvement in Netflix’s cash and debt levels with cash increasing to $300 million to $6.18B with net debt of $7.98B. This is down from net debt of $8.5B in the previous quarter.
The company had a big beat on EPS of $3.10 versus $2.17 expected. This included a $348 million non-cash unrealized gain from FX remeasurement on Euro denominated debt.
A Few More Points:
Netflix does not believe their market is saturated, rather that advertising opens up a new, sizable addressable market. The company offered the following information: “In the 190 countries in which we operate, our $30 billion-plus of annual revenue is roughly 5% of the combined estimated ~$300 billion pay TV/streaming industry, ~$180 billion branded advertising market, and $130 billion consumers spend annually on gaming6. So, we believe that we have a long runway for growth if we can continue to improve our offering steadily over time.”
Early next month, Netflix goes live with its new ad-supported tiers. Netflix has been able to launch its ad platform within 6 months of the announcement. The announcement earlier this month was good news for Netflix investors who entered early despite many institutional analysts predicting it would be six months into 2023 before it rolled out.
Here is what we had stated: “It’s certainly feasible that strong ad partners can get Netflix’s global rollout accomplished in a year’s time – which is why I believe we will hear who Netflix has chosen as soon as Q2 earnings or by Q3 earnings. I don’t think we will need to wait until Q4 2022 as testing is likely to happen sooner.” — this timing is important not only because as investors we don’t have to wait too long to get a glimpse of the impact of the new ad tier (Q4 earnings) but also because this sets up Netflix for next year’s upfronts.
I foresee Netflix doing quite well during next year’s upfront season, which is when prepaid inventory is contracted between high-paying brand advertisers and media companies. Assuming there are no changes, we fully expect to hold our position well into this time frame (Q2 2023). This is primarily because Netflix has very high-quality content and because Pay TV advertisers are in some pain right now with the need to find strong content to place ads.
On the earnings call, management discussed the “collapse of Pay TV” stating they had underappreciated the effects that the Pay TV migration is having on advertisers. They specifically pointed to the 18-49 year old demographic.
Also on the earnings call, management stated they are not expecting any material financial impact this quarter from ads due to the intra-quarter launch. However, over time, the company expects the ad tier to be margin accretive. My personal take is that it can produce a nice boost in subscribers and this glimpse is going to be one that I am very much looking forward to. Management has no visibility at this time as it launches in two weeks so it’s prudent to not guide beyond the visibility they currently have.
Management could not be more clear in their Investor’s Letter or on the earnings call that having the streaming best content in the world is their #1 strategy for success. That is one reason I track statistics such as Netflix’s share of TV time very closely. There was discussion that Netflix fully accepts the cost of the creating content and is instead more focused on getting more value from $1 billion in content than their competitors.
Conclusion:
Given the new ad tier and the popularity of password sharing, I believe Netflix’s revenue estimates over the next few quarters and next fiscal year are quite low. When you combine this with a new cash profile for Netflix, this stock may be entering the perfect storm. Netflix has only been FCF positive in 2020, and has not been FCF positive in any other previous year. We will now be entering two years of FCF positive between 2022 and 2023.