Netflix’s report had some puts and takes.
Positives:
EPS was a beat at $3.29 versus $2.86 expected. The previous free cash flow guide for FY2023 was at $3.5 billion, and the full year guide is now raised to $5 billion this year. The company beat on paid net adds at 5.9 million compared to 2.1 million expected. Notably, the beat on net adds is coming from paid sharing, to where you can pay a lower fee to be added to someone’s account. The beat is not coming from the ad tier.
There was a marginal miss on revenue at $8.18 billion compared to $8.29 billion expected. There was also a marginal miss on forward revenue at $8.52 billion management guidance versus $8.68 billion expected. These things may seem insignificant, but most tech stocks are priced to perfection right now.
The question is why did Netflix have such a big beat on net adds but not on revenue?
Negatives:
This is a blemish because in the past, the region grew 10% in revenue with similar net paid adds (reference Dec 2022 quarter), or there were no new net adds and still grew 9% in revenue (reference September 2022 quarter). Notably, even when Netflix lost 1.3 million subscribers, the company grew UCAN by 10% YoY on CC Basis. Therefore, it is unusual that Netflix did not grow revenue YoY in UCAN region, especially given the net adds.
Almost half of Netflix’s revenue comes from UCAN and so it’s watched closely. According to management, the UCAN region had benefited from increased pricing and is now only reflecting paid sharing plans. The UCAN region resulted in overall ARM being down 1%.
Today, separate from the earnings report, Netflix removed the basic, ad-free option for new subscribers in the United States and United Kingdom. New subscribers will have to pay $6.99 with ads or $15.49 without ads, eliminating the $9.99 tier.
On a side note, the ads ARM is expected to be $8.50, per management comments in the call.
Margins:
Margins were strong. Gross margin was flat yet operating margin was a beat by 330 basis points for an operating margin of 22.3% and operating income of $1.827 billion. Net margin also surpassed expectations by 260 basis points, which flowed to the beat on EPS.
Cash:
As stated, cash was quite strong at $1.44 billion in the quarter, up from $103 million a year ago. Management raised guidance from $3.5 billion in FCF for the fiscal year to $5 billion in the current fiscal year.
Earnings Call:
As stated, the primary blemish is related to UCAN. In the call, management emphasized overall revenue will accelerate yet could have been more clear about UCAN specifically.
This was stated at one point regarding ARM being down next quarter, as well: “But if you think about the drivers of average revenue per member, starting with the revenue drivers that we spoke about a moment ago, you can see our FX neutral, ARM is — it was down 1%, FX neutral in Q2 and we expect similar in Q3, flat to slightly down. That's mostly due to the limited price adjustments we mentioned over the past year in our big revenue markets in advance of rolling out paid sharing.”
Jessica Reif Ehrlich:
“Well, maybe you can help us think through like in UCAN, how much of the ARM growth is a function of add-on members to existing accounts versus new subs signing up to higher priced plans. And it sounds like from your letter that ARM will accelerate in the second half as you get further along in password sharing. Is that correct?”
Spencer Neumann:
“Yeah. Maybe just broadly thinking about our kind of revenue in Q2 and going forward. Jessica, the key is that we delivered revenue in line in Q2 with our expectations and we're on track to accelerate that revenue in Q3 and further accelerated in Q4. That's really our primary objective around revenue acceleration and we're set to deliver on it. But if we step back on thinking about our revenue growth and components overall or within a given region, it's driven by a combination of pricing, volume and new revenue streams like ads.
So if we think about each one of those, so we're now more than a year out from any price adjustments in our big revenue countries. We largely paused them during paid sharing rollout and so that's to be expected. For ads, that new revenue stream, we've expected a gradual revenue build and so that's not expected to be a big contributor this year. So continues to be on target. So most of our revenue growth this year is from growth in volume through new paid memberships and that's largely driven by our paid sharing rollout.”
The Hollywood strike is also a concern although management was bit vague about the implications other than saying: “These strikes, this strike is not an outcome that we wanted” and did not answer the question directly as to how much content they have in the pipeline before they run out. My takeaway was that Netflix’s stock will be impacted the longer the strike continues.
Conclusion:
Having a large beat on paid net adds but not translating that to revenue is not ideal. The company is being clear about revenue acceleration into the back half of the year, which means investors are being asked to be patient. We will likely be patient to some extent, but probably not at this allocation and with these gains. Overall, I imagine we will trim on this report. The stock has done quite well and we’d like to keep some of those gains given the weaker-than-expected quarterly report.