Netflix reported in line on revenue and handily beat on net additions. The miss on EPS is being forgiven (it seems) as the EPS miss is due to FX remeasurement on Euro denominated debt. The market has been overlooking FX adjustments on other companies, as well.
The management team was able to provide a strong guide on free cash flow of $3 billion for FY2023, which is what we wanted to see. They reiterated a consistent operating margin, and most importantly, on the earnings call they said the words “accelerating revenue” starting in Q2. Because that discussion is important, I’ve included excerpts of the transcript below.
On our Q1 Kickoff webinar, we described the types of earnings reports we would want to buy this earnings season, and Netflix ticked those boxes. That is, a stronger bottom line in terms of cash flow, and an acceleration in revenue. The operating margin is expected to be flat but will be higher on absolute profit. We have it penciled in to watch for further improvement on OM in FY2024.
You can access our pre-earnings write-up on the forum here.
Q4 Financials:
Netflix reported revenue of $7.85 billion, in line with the $7.84 billion estimated per analyst consensus. This represents growth of 1.9% or 10% on a constant currency basis. EPS was expected to be $0.50, per analyst consensus. Netflix missed this estimate and reported $0.12 EPS.
The company stated the following:
“EPS in Q4’22 was $0.12 vs. $1.33 in Q4‘21. This was below our $0.36 forecast due to a $462M non-cash unrealized loss from the F/X remeasurement on our Euro denominated debt as a result of the depreciation of the US dollar vs. the Euro during Q4’22."
If you factor in the $462M, it would have been $1.15 EPS.
The guidance for next quarter was in line at $8.17B on revenue compared to analyst estimates of $8.13B. The EPS for Q1 guide was a bit weak, but this is likely due to FX. Analyst expectations for Q1 were $2.98 with management guiding for $2.82 EPS for fiscal Q1.
Paid net additions (or new subscribers) came in at 7.6M compared to 4.5M expected. Analyst consensus ranged between 4M and 5M going into earnings. EMEA had the highest growth followed by APAC. Notably, United States and Canada contributed 1M whereas in the past UCAN was flat or showed nominal churn. As stated on the forum, Netflix will no longer be guiding or reporting on this key metric, and will instead, guide on revenue.
“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.”
Margins:
The margins came in as expected, no surprises in either direction. The reason the margins look weak is because management has stated “The fourth quarter is typically our lowest operating margin quarter of the year as it’s usually our largest quarter in terms of content and marketing spend. In addition, the aforementioned F/X impact has a high flow through to operating income (~75%-80% of the revenue impact) as most of our costs are in US dollars.”
- Gross margin was 31.1% compared to 32% in the year ago quarter.
- Operating margin was 7% compared to 8% in Q4 last year. FY2022 operating margin was 18% although excluding restructuring charges would have been 20%. For FY2023, the guide was 19-20%. The guide for Q1 is 20% which is lower than last year due to content costs.
- Net profits were slim at $55 million compared to $163 million expected. This is where the $462M non-cash F/X remeasurement is reflected.
- Adjusted EBITDA came in at 10.1% for the quarter and 20.4% for FY2022.
Cash Flow
Cash flow for FY2022 came in at $1.6B and management guided for $3 billion in FY2023. 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 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. Note: these numbers have been updated per the Q4 ER. 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 will be able to 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.
That debt level is exorbitant, yet interesting enough, Netflix believes their competitors are faring much worse, per their Investor Letter: “our best estimate is that all of these competitors are losing money on streaming, with aggregate annual direct operating losses this year alone that could be well in excess of $10 billion, compared with our +$5-$6 billion of annual operating profit.”
Earnings Call:
In terms of cutting off password sharing, this was one of the most important comments on the call, where management is implying an acceleration in revenue sometime in Q2-Q3.
Jessica Reif Erlich (Moderator)
Can you provide any details, including the time frame for converting borrowers to paying accounts?
Spence Neumann (CFO)
“[…] so those dynamics that Greg just walked through, because of that as we kind of start to roll this out later in Q1, based on the timing, what we talked about is that we will have modest growth we expect in paid net adds in Q1, but kind of atypical seasonality, where typically Q2 would be a softer pay-at-ad quarter. It will probably be a larger paid net add quarter. And most importantly, what we’re most focused on is obviously revenue. That is our primary metric. And what you see is in the guide, these revenue initiatives between paid sharing rolling out and then scaling ads, you don’t see much of that in Q1, which is why we are forecasting 8% growth FX neutral in Q1 revenue. But throughout the course of the year, we would expect to see accelerating revenue growth as we roll out page sharing broadly across our business and then obviously, scale adds throughout the year, which is a more gradual build. So I just want to kind of highlight that, and that’s kind of what you’re seeing in the guidance.”
Jessica Reif Erlich (Moderator)
And given the revenue drivers of paid sharing and advertising, how are you thinking about price increases in the current year? Is it just too complicated? How are you thinking about it?
Greg Peters (Co-CEO):
Well, I would say the two initiatives that you described represent the bulk of our pricing strategy in ‘23. We anticipate that they’ll both be revenue positive, revenue accretive significantly […] And then we will go back and opportunistically ask for them to pay a little bit more so that keep this virtuous cycle going and really invest that back into incredible content and stories.
Ted Sarandos (Co-CEO):
[…] And so it’s across film, across television. It’s the content that people must see and then it’s on Netflix gives us the ability to do that. And we are super proud of the team and their ability to keep delivering on that month-in and month-out, and quarter-in and quarter-out and continuing to grow in all these different market segments that our consumers really care about. So, that to me, is core to all these initiatives working, and we have got the wind at our back on that right now.
My note: I wanted to bold the last part about content because I believe this is very important as to why Netflix has the brand leverage to cut off passwords and offer an ad tier successfully. It’s partly due to offering so much content that people “must see.” Wednesday saw 341 million hours viewed in one week and holds the new record over Stranger Things 4.
Below is a Nielsen ranking of the Top 10 Shows streamed in a given week published on Deadline around Thanksgiving. All 10 spots are taken by Netflix. Although this fluctuates and is only a sample of one week’s rankings, it demonstrates the type of influence Netflix has on viewership and engagement, competitively speaking.
Here was another important comment about revenue acceleration and an expanding bottom line when the moderator asked about Free Cash Flow (notably, they did not correct her when she said FY2024 FCF)
Jessica Reif Erlich:
So, let’s move away from content then. So, free cash flow. First of all, like, what an inflection point, $1.6 billion in ‘22, roughly $3 billion in ‘23, $4 billion plus probably in ‘24. Can you just talk about – historically, you have been more build than buy. Is there any change in philosophy as cash starts accelerating? Can you talk about overall capital priorities? And what’s driving that operating margin increase?
Spence Neumann:
[..] We are now into New Year, so we take it forward to January ‘23 to current rates, and that’s a range of our operating margin guidance of 18% to 20%. So, now FX neutral for ‘23, we are going to manage within that band to deliver at least within 18% to 20% operating margin guide. So, that is growing margins, growing absolute profit. And really what’s reflected in there is that this – we have high confidence in our ability to accelerate revenue throughout the course of the year as we scale ads and we launch paid sharing. We have got high confidence in improving the service and the strength of our content slate with everything that Ted discussed here on the call. And we are also continuing to manage our cost structure with increasing discipline. You saw that in the back half of ‘22 with our slowing expense growth and we will carry that through similarly in ‘23. 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.
We will obviously know a lot more over the next couple of quarters, a few quarters as we roll out paid sharing, and we will update guidance as appropriate. 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.
Conclusion:
Management sounded more confident than usual about the password sharing and the new ad tier, and I’m guessing the confidence comes from the testing they’ve been doing. For us investors, it sounds like they will be right on time with a Q2-Q3 revenue acceleration. I did not expect them to blatantly state there would be a revenue acceleration after Q1, but in this tough market, I’ll take it.
The company also did a good job of discussing a better bottom line, of sorts. The free cash flow is clearly improving yet I’ve also seen analyst notes that point toward a better operating margin being forecast for FY2024. Overall, the comments listed above hinted towards higher revenue while confirming a consistent to improving bottom line.
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.
I would also say that Reid Hastings stepping down should not be a huge surprise as he’s been Co-CEO for over two years since Ted Sarandos became Co-CEO in July of 2020. I kinda got the feeling on the call that perhaps Hastings is stepping down right now because the company is about to have some strong quarters – that’s pure speculation about his chosen timing – but I figure if a company has become your magnum opus, it makes sense to exit when it’s on solid ground.