• Netflix’s pivots – which is the password sharing and ad tier – are expected to show up in Q2 for password sharing and then Q3/Q4 for the ad tier whereas previously the goal was to have impact by Q1 and Q2. The initial signs of PW sharing are encouraging. More on this below. The ad tier is too early to have any initial impressions or data to work with, although long-term it will be accretive to margins and should have a positive impact on the top line, as well.
• FCF was impressive at $2.17 billion with management raising the FY guidance to $3.5 billion.
• Over the past few quarters, Netflix’s after hour price activity can be volatile. I believe this is due to FX headwinds, which are often reported as a miss, but then the market proves to be forgiving of the lower revenue/EPS numbers in favor of constant currency. This is my best guess as it’s been volatile for a few quarters, which leads me to believe machines are trying to catch up to the reported numbers versus constant currency basis. Notably, the stock price regained its losses before the earnings call was released.
• The ad tier could see a flurry of headlines next month for the upfront season. The upfront season’s best-case scenario is committed upfront spend for 13 million subscribers, which is a small audience compared to Netflix’s roughly 220 million subscribers. Our plan is to follow price for this stock and to be patient long-term as we are optimistic on the outcome.
• The I/O Fund has been planning on cutting back on our Netflix position, which was outlined before earnings here and also in Knox’s Position Report here.
• The Netflix pre-Earnings report found here has additional information to supplement the post-earnings report below.

Financials:

Netflix missed on revenue and was inline on EPS. FX headwinds create mixed reactions to this particular earnings report, and I suspect the strong cash flow also helped price after hours. Last quarter, a large EPS miss was reported whereas it was due to a FX adjustment. 

This quarter, revenue was $8.162 billion or $8.5 billion on a constant currency basis compared to $8.18 billion estimated. This is widely reported as a miss, but on the other hand, the market has been forgiving of FX headwinds with other companies.

The guide was lower than expected at $8.24 billion compared to $8.48 billion expected. The company is pushing out its expectations for the new ad tier to drive top line growth in Q3 whereas the previous expectation is that this would start to show up in Q2. Password sharing will be “broadly” rolled out including in the United States in Q2.

EPS of $2.88 was in line. EPS for next quarter is a miss at $3.06 EPS expected versus $2.84 EPS guided.

The gross margin is 400 bps lower this year at 41.20% with flat gross profit of $3.35 billion compared to $3.5 billion last year. The operating margin of 21% was also lower compared to last year’s 25% OPM yet this met management’s guide for an operating margin of 18% to 20%. Notably, management had stated last quarter that “operating margin to be down YoY due to timing of content spend.” Similar to operating margin, net margin and adjusted EBITDA were lower but within expectations.

In the comments on the forum, you can read from forum members on why margins are the most important line item for Netflix moving forward.

Netflix exceeded on free cash flow at $2.1 billion compared to $3 billion for the full year last year. The company is raising full year guidance on free cash flow to $3.5 billion. The free cash flow margin is more than double from last year at 25.9% compared to 10.19% in the year ago quarter.

Gross debt is still high at $14.5 billion, which is inherent to the business model. However, net debt is improving at 1.1X compared to 1.3X last quarter with net debt of $6.7 billion compared to $8.37 billion last quarter.

Netflix still trails other FAANGs on its investment rating, yet it’s notable the company has seen an upgrade from Moody’s from junk to investment grade. Netflix has been the black sheep of the FAANGs in this regard, however, a large part of our thesis is based on the company’s change in profile in terms of bottom-line strength.

On another positive note, Moody’s stated the following regarding Netflix’s ad tier: “Moody’s anticipates that growth in subscribers from the recently launched ad supported service will be gradual but steady and provide a strong long-term opportunity for revenue growth.”

Key Metrics & Additional Notes:

Password Sharing & Geographic Regions:

Global paid adds of 1.75M came in slightly shy of analyst estimates of 1.8M.

For password sharing, Latin America provides some clues as to how a broader rollout will perform. According to management there was a cancel reaction which later eased. The region reported a loss of net adds of (0.4M) compared to net adds of 1.76M in Latin American last quarter, yet the revenue was up 7% YoY (+13% on constant currency basis).

The company stated that other regions, such as Canada, were “directionally consistent with what we saw in Latin America.”

There was a similar pattern in the United States Canada (UCAN) region where there was low net adds yet higher revenue growth. The region reported 0.1 net additions with revenue up 8% YoY.

In the year ago quarter, these regions were flat or reported a decline. There can also be churn coming out of Q4 for Netflix since that quarter has high net adds. 

Another observation is that LatAm and UCAN both had expanding Arm, or average revenue per membership, whereas the other two regions saw a lower Arm. This could be encouraging in terms of a broader rollout on password sharing driving more top line growth in the second half of the year.

• UCAN up +9% from $14.91 to $16.18
• LatAm up +3% from $8.37 to $8.60
• EMEA down (6%) at $10.89 this quarter compared to $11.56 in the year ago quarter
• APAC down (13%) at $8.03 this quarter compared to $9.21 a year ago

Notably, average paid membership increased in APAC, which were up 17%. This is clearly a large region but there’s been some attention on India specifically where Netflix has lowered prices. This would make sense to where net adds increased but ARM decreased. 

Ad Tier:

Upfront season is coming, which means Netflix will likely have to state the company’s expected scale for the ad tier come Q3/Q4. Right now, the company is not guiding for this but analysts believe it will be in the 13M range.

We covered this in our Essentials Pre-ER write up. Per Forbes/Bloomberg: “After a slow start Netflix ad tier has been gaining traction with U.S. subscribers. After analyzing their internal data, BloombergBloomberg reported in its first two months, Netflix had one million active users. Before its launch, Netflix had projected 1.1 million by year end 2022 increasing to 13.3 million by the third quarter 2023. Industry analysts project Netflix could eventually wind up with 30 million U.S. subscribers on its ad supported tier. The U.S. is one of the 12 markets where Netflix is now selling ads. At its most recent earnings report Netflix had 74 million total U.S. subscribers with 231 million worldwide.”

The company continues to believe the ad tier will be accretive to the bottom line, especially considering the ad tier will monetize better than its basic and standard plans. The ad tier will be $6.99 per month plus ad dollars. With that, management believes there will be “50% or more incremental profit contribution to the business.”

Earnings Call:

According to management on the call, Q2 is the quarter to watch for password sharing.

“Yeah. So that launch we are doing in Q2 is a very broad launch, it includes the United States, includes many, many other countries. I mean, we reserve the right for some countries where we think there’s a different approach. But I would say the bulk of our countries, and certainly, when you think about it from a revenue perspective, the vast majority will be rolling out in Q2.”

The ad tier is expected to be accretive to the company’s margins at 50% or higher.

“Jessica Reif Erlich (moderator)

And then I just wanted to clarify something, Spence, I think you said, this is a 50% margin. I mean, typically, advertising could be as high as 80% or 85% margins. Is that — do you expect to build up to that or do you think it’s really just a 50%-plus business?

Spence Neumann

Well, I put plus in there. So I said at least 50% and it was really just to highlight the fact that we are still in startup mode of this business and so leaning a little conservative. But, yes, our expectations over time is that it would be meaningfully over 50%, but I don’t want to give a specific number yet.”

Conclusion:

The impact from password sharing and the ad tier is later than originally anticipated (Q2 for PW sharing and Q3/Q4 for the ad tier), but it’s not that surprising because these are monumental changes that require time. In this regard, we are happy to be patient. Part of the thesis was the bottom line and the cash flow, and the company has been performing here, as expected.

However, price was already looking stretched and we may trim the position according to technicals. The stock is up about 100% from the June low so the market may be getting antsy to pocket some of the gains from the second half of last year.

Recommended Reading: 

• Essentials April Stock Tip: Our Netflix Buy/Sell Plan
• Netflix Stock Will Be A FAANG Again
• Netflix Stock Stronger Than It Seems Following Q2 Earnings
• Netflix Stock Could Rally With Ad-Supported Content

Netflix is coming into a nail biter of a report. The ad tier will be under pressure in terms of how it’s performed in various regions when the company rolled it out in January. There is a report from Bloomberg that Netflix added 1 million in their first two months. An analyst noted below is expecting 1.75M total for the quarter. Overall, the goal is to reach 13M by Q3 2023.

Fundamentally, Netflix has become a different stock over the past year. In addition to the new advertising tier, which we hope is a catalyst, we own Netflix due to the underlying fundamental strength. According to analyst estimates, Netflix bottomed on revenue growth last quarter with noticeable improvement in H2 2023. The company has been transparent on how they will meet guidance on margins, including free cash flow.

The EPS is also rebounding with analyst consensus showing a 100% increase on EPS over the next two years. This is subject to change, but helps complete the picture as to why we’ve been covering Netflix closely.

Netflix is our largest position right now, thus we guard it closely. Our service is setup to show our Members what it looks like to realistically manage a portfolio. We do not provide an endless pipeline of stock tips. We carefully build positions and we carefully take gains, at times. We will gladly talk about the same stock dozens of times if it’s going to make us money.

Those who are addicted to a constant stream of information, and who are addicted to new stock tips, will get hurt in 2023. There simply aren’t that many great tech stocks in the current macro environment. If there’s anything you get from our service, I hope it’s that one important take away. 2023 is the year to hold fewer stocks, and to know them well.

Active management helps to participate in the gains. For example, to illustrate — Netflix is down (42%) from Jan 1st, 2022 and it’s up 61% from October 11th. This is why active management is well worth our time.

Buy Plan/Sell Plan – April Stock Tip:

By Knox Ridley

Between $379-$420, Netflix will be in the high-risk zone. Do not be shocked to see us cut NFLX in half if we get into that zone. If we do get there, this will be a 20% to 30% gain from when we recommended the stock for Essentials and a gain of 75% gain from our first entry in August on the Pro/Advanced side. Normally, our Essentials plan would have participated in the higher gains, but we had not launched the service yet. Our Essentials Newsletter went live around Thanksgiving.

Netflix is working on the final 5th wave of a very large degree pattern. It bottomed in May of 2022, so it has taken this pattern almost a full year to complete. Once NFLX gets into the $379-$412 region, the pattern will have met the minimum requirements for completion. We would consider that region to come with heightened risk. In fact, we expect to reduce our position substantially if we get to that price target. This will remain our primary thesis as long as price holds the $300 region. For long-term buyers, we believe the time to accumulate is not now.

What we are watching for:

• There is outsized pressure on the advertising tier given the global rollout in test regions. Although password sharing was cutoff mid-quarter, Wall Street will want to see evidence this strategic move will be accretive. Per channel checks noted below, the Street is expecting 1.75M subscribers from the ad tier, although notably, Netflix no longer reports subscriber numbers.

  Per Forbes/Bloomberg: “After a slow start Netflix ad tier has been gaining traction with U.S. subscribers. After analyzing their internal data, BloombergBloomberg reported in its first two months, Netflix had one million active users. Before its launch, Netflix had projected 1.1 million by year end 2022 increasing to 13.3 million by the third quarter 2023. Industry analysts project Netflix could eventually wind up with 30 million U.S. subscribers on its ad supported tier. The U.S. is one of the 12 markets where Netflix is now selling ads. At its most recent earnings report Netflix had 74 million total U.S. subscribers with 231 million worldwide.”

• Netflix has been cutting costs this quarter. We want to see the company maintain bottom line strength. For Netflix, sometimes misses on the bottom line are due to FX headwinds, and other times they’re due to lumpy content costs.
• Q1 is expected to be a weaker quarter for the year on operating margins with management stating “For Q1’23, we expect operating margin to be down year over year (20% vs. 25%) due primarily to the timing of content spend.” This would be 18-20% operating margin, down from a 25% margin in the year ago quarter.
• Social media has a hard time dissecting the lumpiness in the new macro. Nvidia was a target for shorts because of this, what they didn’t realize is that NVDA had bottomed fundamentally in the prior quarter. In a nutshell, if the bottom-line miss is transitory – FX headwinds or lumpy content costs – the market will be more forgiving.
• If Netflix’s management has guided correctly, the company has bottomed. I explain this more below (this depends on how management guided). Notably, this is the first quarter without Reed Hastings as CEO although the C-suite team has been working with Hastings for years on this transition.
• The guide I’m referring to from the last earnings call is this: “So, that all lends itself to our focus, which is kind of healthy growing double-digit revenue growth and accelerating that revenue growth throughout the year, expanding our – both our absolute profit and profit margin and then growing positive free cash flow.

Financials:

Per analyst consensus, the expected acceleration is the following:

Estimated Revenue & Estimated EPS:

• Q4: 1.9% Actual
• Q1E: 3.86%
• Q2E: 6.37%
• Q3E: 10.57%
• Q4E: 13.5%

On a fiscal year basis, Netflix is expected to report:

• FY2022 Actual: 6.46%
• FY2023E: 8.5%
• FY2024E: 11.9%

This is not a hypergrowth profile, rather what the market will want to see is quality growth. For our purposes, this can be roughly defined as an acceleration in growth that doesn’t come at the expense of the bottom line.

For EPS, Netflix is expected to report:

• Q3 Actual: $2.16 EPS
• Q4 Actual: $0.51 EPS
• Q1E: $2.87 EPS
• Q2E: $3.06 EPS
• Q3E: $3.30 EPS

I included Q3 since Q4 is often much lower than the other quarters. Although the revenue acceleration may be mild for growth investors, the bottom line is expected to grow well through FY2025. There’s a lot that has to happen between now and FY2025, but it’s good to see analysts have confidence that Netflix could double its bottom line over the next two years. 

Q3 Actual was $2.16 EPS and consensus from six analysts is EPS of $4.08 in Q3 Sep 2024.

Gentle reminder that FX can result in an advertised EPS number being very low/big miss. Last quarter, the $1.15 EPS was reported as $0.12. Per the write-up: “

“FX can be a lot to unpack but I believe the market is taking into account the $462 million FX remeasurement and seeing this as $1.15 EPS rather than $0.12 EPS. This is why we want to do proper due diligence (and steer clear of social media for investment research — that's an understatement) as there was some confusion over this that negatively spiraled on Twitter.”

Margins:

Regarding margins, this is what the management said in full: “We have been targeting a FY23 operating margin of 19%-20% based on F/X rates at the beginning of 2022. We now expect to deliver roughly 21%-22% operating margin on this basis (above the 19%-20% range). Rolling forward to F/X rates as of January 1, 2023, this translates into a FY23 operating margin target of 18%-20%. For Q1’23, we expect operating margin to be down year over year (20% vs. 25%) due primarily to the timing of content spend.”

• Last quarter, Netflix had a gross margin of 31%
• The operating margin guide works out to 18% to 20% margin, down from 25% in the year ago quarter.
• Due to FX headwinds, the FY2023 operating margin will be in the 18% to 20% range. The market has been forgiving FX headwinds, partly due to a global company being desirable for diversification while the United States see a weak consumer.
• The net margin can be low at first glance due to FX headwinds. It was 20% in the year ago quarter yet was 1% with FX last quarter. Without FX, it was 6.5% last quarter. This included a $462M non-cash FX remeasurement.

Cash Flow:

Cash flow for FY2022 came in at $1.6B and management guided for $3 billion in FY2023. Last year, Q1 and Q3 were very strong on FCF and Q2 and Q4 were weaker. This goes back to lumpy content spend, so investors should be prepared for this and not expect a linear path to the $3 billion.

“But that’s what plays through and then also plays through that cash flow generation that you see, where we believe with all those dynamics and managing at about the same level of cash content spend that we will have more than $3 billion, at least $3 billion of free cash flow in the year.”

The $1.6B in FY2022 compares to ($158) million for FY2021. Overall, this is a very different Netflix today as the company lost over ($3) billion in free cash flow in 2019.

The in-house moderator also hinted toward “$4 billion plus in 2024” and management did not correct her. We would need an official guide but I have this number penciled in for next year. 

The company’s gross debt is $14.3 billion and the company’s net debt is $8.37 billion or 1.3X LTM EBITDA with $6.05 billion in cash. You’ll notice the LTM slightly ticked up from 1.2X LTM last quarter. To reiterate, this is because Q4 tends to be weaker than other quarters. With the $3B in FCF expected in FY2023, Netflix can get the LTM below 1X. 

The gross debt will still outweigh cash for some time. The company has stated investors can continue to expect $10 to $15 billion in gross debt. According to the last 10-Q, the company’s next payment of $400 million is due in October of 2024.

It’s understandable if you’re scratching your head at Netflix’s debt. This is part and parcel with Netflix’s business model. The market has come to accept this over the past decade-plus. You’ll have to decide for yourself if the business model works for your risk profile.

Noteworthy:

The upfront season starts in May. We covered this in December when we said:

“The Second Chess Move is called The Upfront Season 

Every year, advertisers and agencies negotiate and sign year-long deals with TV networks as well as connected TV platforms to commit to spend an agreed amount on ads. They call this the upfront season. Last year, NBCUniversal clocked $7 billion in the upfront season and Roku grew it’s upfront spend from$500 million to $1 billion.

The 2023-2024 upfront season will take place in the late Spring and early summer of 2023.”

Reed Hastings has stepped down. Ted Sarandos and Greg Peters are Co-CEOs. Ted Sarandos became Co-CEO in July of 2020.

The revenue drivers being closely watched are the paid sharing (cutoff passwords) and the ad tier. Management stated they are expecting modest growth for Q1 on paid net adds for subscribers and a larger net add quarter in Q2. Seasonally, Q2 is a softer quarter for Netflix. Regardless, Netflix is no longer going to report on net adds. Instead, they expect analysts and investors to rely on revenue growth. 

“As discussed in previous letters, we are increasingly focused on revenue as our primary top line metric. This will become particularly important heading into 2023 as we develop new revenue streams like advertising and paid sharing, where membership is just one component of our revenue growth. So, starting with our Q4’22 letter in January of 2023, we’ll continue to provide guidance for revenue, operating income, operating margin, net income, EPS and fully diluted shares outstanding for the following quarter, but not paid membership. Similar to our regional membership disclosure, we’ll continue to report our global and regional membership each quarter as part of our earnings release.” 

Recent Headlines:

Per Bloomberg, Netflix’s ad tier reached 1M MAU after the second month. According to the report: “Most of the people signing up for the ad tier are new customers or lapsed customers, not people who immediately changed plans. The ad tier now accounts for about 20% of new sign-ups in the US, per Antenna.”

Also, per the Bloomberg report: “Netflix already has 74 million customers in the US, which means it doesn’t have that many potential new viewers. Analysts estimate the ad tier could bring in between 15 million and 30 million customers in the US, but that won’t be right away.”

My note: If it materializes, that’s some serious growth for a company that had plateaued. Reference above where management told advertisers to expect 1.75M by Q1 and Bloomberg reported up to 13 million by Q3 2023.

In February, Netflix tested lowering prices in a few regions. Per Reuters, “the price cuts took place in some countries in the Middle East, sub-Saharan African, Latin America and Asia.” See analyst note below where this was successful in India last December.

The company is scaling back on costs by restructuring its film group. Per Reuters, “Netflix will combine its small and mid-sized picture production units, cut a few jobs, scale back its output to ensure high quality titles and centralize decision-making.”

Netflix offers a video game service on smartphones and tablets, and is now bringing the video game service to televisions. Per Bloomberg: “Code hidden within Netflix’s app includes references to games played on TVs, signaling that such a plan is in motion. The code also mentions using phones as video-game controllers.” Per the report, the goal would be to attract and retain more subscribers.

Per TechCrunch, Netflix has 40 games ready to launch this year and 70 games in development.

What Analysts are Saying/Channel Checks:

“Netflix has told advertisers in the past 10 days that new sign-ups for the tier with ads had doubled in January over December, though Netflix didn't tell advertisers how many sign-ups that amounted to, people familiar with the matter told The Information's Sahil Patel. Last fall, when first pitching the ad offering, the company had told advertisers it expected the tier would draw 1.75M subscribers by the end of the first quarter, the equivalent of just 2.4% of Netflix's North American subscriber base at the end of December, the report noted.”

“Guggenheim analyst Michael Morris notes that over the past week, there have been several reports regarding Netflix pricing cuts across various markets in Eastern Europe, Latin America, and Southeast Asia, which is not the first time the company has changed prices. In December 2021, Netflix cut prices in India as it faced competition from other streaming services. Last week, co-CEO Ted Sarandos highlighted the company's success in India over the past year with viewership up 30% in 2022 and revenue increasing 25%, Guggenheim says. The firm believes Netflix is looking to extend this strategy across similar markets around the world. Guggenheim has a Buy rating on the shares.” 

“Oppenheimer analyst Jason Helfstein thinks Netflix shares are at attractive levels after dropping 22% from the post-Q4 highs on fears around higher churn from enforcing password sharing and a slower advertising launch. The company's Q1 engagement is trending weaker than the previous two quarters, but in line with Netflix's previous six-quarter average, the analyst tells investors in a research note.” 

“Citi analyst Jason Bazinet raised the firm's price target on Netflix to $400 from $395 and keeps a Buy rating on the shares. Netflix recently cut prices by 50% across 100 smaller markets, which represent 6% of its subscribers, the analyst tells investors in a research note. The firm believes "such dramatic" price reductions across so many markets "confused the Street." Citi thinks the price cuts are linked to password sharing enforcement and could boost Netflix's aggregate revenue by 1%. It says the "far more interesting question" is what Netflix will do in the 90 markets that do not have an advertising tier and have not received a large price cut. Netflix can either not enforce password sharing rules, launch an ad tier, or expand the price cuts, according to Citi. The firm updated its model to reflect the price reductions and updated current rates.” 

“JPMorgan says there has been "considerable early pushback" around Netflix's Paid Sharing launches in select international markets, which is driving greater concerns around near-term churn. Apptopia downloads data suggests increased volatility across all four Paid Sharing markets since the rollout, and the headlines may also be impacting other markets where Paid Sharing has not yet been rolled out, including the U.S., the analyst tells investors in a research note. The firm sees potential risk to Netflix's projection for more net adds in Q2 than Q1. However, JPMorgan expects Netflix to continue down the path of transitioning users away from widespread account sharing. Ultimately it expects Netflix to generate more revenue through the combination of extra members and new standalone accounts. The firm recognizes the near-term "noise" but keeps an Overweight rating on the shares with a $390 price target.”

Deep dives, trade alerts, a forum and weekly webinars on the I/O Fund portfolio are offered on our premium service, you can find out more information here.here.

The I/O Fund built a position in Netflix with real-time trade alerts starting with an entry at $220.71 on August 30th and at $255.08 on November 7th.

After seeing gains of 43.8% from the first entry and gains of 24.4% from the second entry, Knox then trimmed some of the position to take profits.

For our Essentials Members, Knox will release a private video next week that discusses our plan for building this position and/or our plans to take profits in the future. This video will be similar to the information provided above regarding our positioning but will be forward-looking on what entries we plan to do next OR if we plan to trim and add again at a later time.

Below, is a fundamental analysis on Netflix including the specific reason that Q1 and Q2 could be “the quarters” for Netflix to become a stock market darling.

Please note: We are not financial advisors and our disclosure regarding this is at the bottom of the article.

Our goal is to do the following:

• Provide you with a December stock pick that we believe may be the top stock of 2023. We want to give you information around the specific catalysts we are expecting in Q1 and again in Q2 that has made Netflix a buy off the August lows.
• We want to provide real investment tools to our Essentials members by providing the same level of technical analysis we use for our portfolio and we use on the Advanced Market Signals service to time entries and exits. This includes allocations (the #1 tool for risk management) and will be provided early next week on a recorded video presented by Knox, the I/O Fund portfolio manager.
• We do not think blanket BUY recommendations are helpful as the market is tumultuous and complex. We are real investors and everything we do is actionable for stock investors. The material you receive on this site is anchored to real decisions we are making with our own portfolio. If it’s not impactful, we will not write the content or produce the video. This is different than other sites that simply fill content pipelines to “get something out” so their customers are satisfied. This is why we believe we offer some of the highest quality content across research sites — the content is being used for real investment decisions and there is zero fluff.

Background on Netflix in 2022:

Below is a brief overview of Netflix’s ad opportunity before we discuss the specific catalysts coming in Q1 and Q2 of 2023.

Netflix’s stock was down a staggering 71% this year. The stock’s fall from grace included dropping its FAANG-status as the company’s market cap has decreased from $300 billion to $75 billion. This was partly due to the company reporting it lost subscribers for the first time since 2011, with a loss of 200,000 subscribers in the most recent quarter. The company also forecast a decline of 2 million paid subscribers for the second quarter.

The earnings report caused the stock to lose 35% of its value over night. Bill Ackman sold his Netflix shares for a loss of $450 million in three months, with some critics goading him for his decision while others congratulated Pershing Capital for being bold and walking away from a losing position.

Meanwhile, our focus was elsewhere.Meanwhile, our focus was elsewhere.

In our Netflix coverage following its earnings report, we had stated “we can’t help but salivate” over which ad platform Netflix might choose to power ads to hundreds of millions of viewers. Primarily, this is because we have consistently discussed why the trend of CTV ads has plenty of runway even during an epic market selloff.

In other words, I would argue the day that Netflix’s stock price dropped 35% was consequently one of the most important days in the company’s history in terms of its chances for a boost in revenue and a renewed uptrend.

Patience, though, will be required, as Netflix has work to do. We prefer to get in front of the market instead of wait for the market to put the pieces together on what this global juggernaut is setting up to do.

The path to adding more subscribers is finally clear for Netflix and will pay off in 2023 especially during times of inflation or muted consumer confidence as it drives down household costs across fragmented subscriptions.

Ad-Supported Video on Demand (AVOD)

The acronyms AVOD and CTV ads (connected TV) should be added to your investment vocabular as this is the most investable trend in media today. Ad-supported video on demand (AVOD) refers to streaming subscription services that supplement with ads or streaming services that are entirely ad-supported. CTV ads are often synonymous with AVOD, however, it can also refer to Broadcast Video on Demand (BVOD) for when live broadcast content is streamed over the internet.

Mobile ads have flatlined yet AVOD is in its early stages of growth. This will become especially apparent during times of economic hardship as subscribers trim back on their many streaming subscriptions and turn to ad-supported content to drive down costs.

We had written an editorial a year ago on Forbes called the Crucial Difference between Netflix and Roku Stock. At the time, we pointed out that: “we believe first-party data for connected TV ads is a significant trend moving into 2021 and an important distinction from subscription-video on demand (SVOD) […] Ad-Video on Demand (AVOD) has an approximate ten-year runway as the trend began taking shape when Roku launched its ad platform in late 2018/early 2019. There were AVOD players in the space before this, but the budgets were negligible.”

Why was mobile capable of capturing such large budgets? Because of first-party data which traditional TV lacks. CTV ads are also capable of capturing large budgets because advertisers are willing to pay more for targeted ads.

Due to your viewing habits, Netflix knows a lot about you. Selling this to advertisers emulates more closely the level of ad demand a company like Facebook would see, who also powers ads with behavioral-level data.

The Market Mistakenly Thinks Netflix is Saturated

There is immense opportunity when a stock investor can prove the market is wrong about a company. With Netflix, a leading line item that investors must be confident on is that the company can grow its user base.

Source: Nielsen

Netflix is tied with YouTube on total viewing time but there’s a catch. Netflix has only 223 million subscribers and YouTube has over 2 billion due to its digital video app. For most purposes, these two are not truly competitors, rather YouTube is a hybrid between a social mobile app and a CTV streaming service. YouTube TV has a mere 5 million subscribers.

What matters most to advertisers is time spent watching content and Netflix clearly wears the crown in the streaming wars.

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 gaming. So, we believe that we have a long runway for growth if we can continue to improve our offering steadily over time.”

We had stressed in our previous coverage that the lagging discussion on Netflix is that there was a subscriber decline in Q1 of 200,000, excluding Russia and a subscriber decline of 970,000 in Q2.

While critics believe this is due to saturation, it’s much more likely the decline is coming from a pull forward due to Covid as all media stocks – both streaming and social media – demonstrated outsized audience growth through Q2 2021.

Therefore, Netflix is lapping some tough quarters for audience growth comps and announced in April their plan to have an ad tier to help combat this.

Management’s willingness to combat subscriber falloff with an ad tier is why we entered in August prior to the subscriber beat.

Another important point we had highlighted was there is already evidence that Netflix is taking more market share than its peers. In fact, Nielsen raised Netflix’s market share earlier this year for engagement to 7.7% from 6.6%, which puts Netflix in the lead over any other competing subscription service.

Q3 Netflix Earnings Results:

Netflix comfortably beat earnings estimates 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. This will be the largest account growth since Q3 2021.

Why Q1 is Critical for Netflix’s 2023 Stock Trajectory

There are two chess moves on the table that can help propel Netflix to become a leading stock in 2023. The first is the moment when Netflix simultaneously cuts off password sharing while having the ad-supported tier available to the customers being cut off from sharing accounts.

Netflix has an estimated 100 million rogue subscribers who are sharing passwords with friends and family members. It’s this cohort of 100 million password sharing fans that the ad-supported tier is squarely aimed at converting.

Let’s look at what management has said:

“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.”

Translation: In early 2023, Netflix is going to cut off the 100 million and offer them two options: 1) pay to be an extra member on the family plan or 2) export your profile, keep your viewing data, and pay for a lower priced ad-supported plan.

Patience from investors is required because Netflix is the first tech company in our universe to report every quarter. Netflix will not have this rolled out for the Q1 guide coming in mid-January but we do believe it will show up by the full quarter Q1 report in April with an informed guide for Q2.

The Second Chess Move is called The Upfront Season

Every year, advertisers and agencies negotiate and sign year-long deals with TV networks as well as connected TV platforms to commit to spend an agreed amount on ads. They call this the upfront season. Last year, NBCUniversal clocked $7 billion in the upfront season and Roku grew it’s upfront spend from$500 million to $1 billion.

The 2023-2024 upfront season will take place in the late Spring and early summer of 2023.

Netflix is a $30 billion company and so something along the lines of a $7 billion upfront may seem small. However, if you go back to the Nielsen pie chart that shows viewing time, you’ll see that NBCUniversal doesn’t even make the list, representing less than 1% of viewing time. Disney makes the list at 1.9% and had a $9 billion upfront season.

I won’t give you an exact number on what this upfront season will pull for Netflix as their AVOD subscriber base will not be mature yet. Meaning, it may be more in the category of the lower percentage streaming services on the ad-supported side. What matters is that even a $7 billion or $9 billion up front (let’s think positive here based on the comps) would result in a 20%+ boost in revenue.

If the two chess moves line up, they will both be a strong statement the market is wrong on Netflix’s saturation. the market is wrong on Netflix’s saturation. 

Netflix is trading a historic low on both its sales valuation and earnings-based valuations. However, is now the time to buy or is it better to wait for a renewed uptrend? We fully believe the single most important time to buy is when the broad market participates (Nasdaq, S&P 500).

Next week, Knox Ridley will record a special Netflix webinar for you as part of your Essentials package going over Netflix’s technical setup in detail so our Essentials Members are as informed as possible.

As you know, we can’t control the market – what we can do is tell you what we do with our money including when we buy/sell/add/trim and why.

Look for that YouTube video published on our Essentials site next week.

Thank you for being a Founding Member to our Essentials Plan. We officially launched the plan last week are excited for this new tier to our analysis.

Disclosure: The I/O Fund conducts research and draws conclusions for the company’s portfolio. We then share that information with our readers and offer real-time trade notifications. This is not a guarantee of a stock’s performance and it is not financial advice. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis. The I/O Fund owns Netflix at time of writing.