Over the last two years, Netflix has become a remarkable comeback story on the bottom line as the company improved its cash profile from negative (-$3.3 billion) in 2019 to a positive $1.6 billion in 2022.
By raising free cash flow guidance every quarter this year, FCF for 2023 will now come in at $6.5 billion. Of the $6.5 billion, $1 billion is from the Writers and Actors Strike. When adjusting for this, FCF is at $5.5 billion, which more realistically sets expectations for 2024, when content spending will be higher than in 2023. The FCF guide is significantly higher than the initial $3 billion guide during Q4 2022 results. The growth in cash was central to our original entry and decision to build the position.
Thanks to the ad tier, Netflix is expected to be the FAANG which grows the most between now and 2030 in terms of operating cash flow margin (OCF), from 12.4% to 28.5% in 2030. Notably, most FAANGs are at this percentage today except Amazon. In terms of last year, this helps illustrate the remarkable comeback Netflix has seen on its bottom line.
Cutting off password sharing has propped the company’s growth recently with paid memberships doubling its growth rate from 4.5% in Q3 2022 to 10.8% in Q3 2023. This led to Netflix’s net subscriber additions totalling more than 1 million in every geographic segment in both Q2 and Q3 – the first time in back-to-back quarters in more than 3 years.
Per our last write-up:
“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.”
As stated above, the ad roll-out is not contributing meaningfully yet. Ads are a historical pivot for the subscription video on demand (SVOD) juggernaut, and the roll-out has seen some minor delays. This is the primary focus as we move into 2024, and one that requires some speculation as to how it will perform.
Looking forward, there promising signs that Netflix’s ad tier is beginning to ramp. The company recently announced that the ad-tier had surpassed 23 million MAUs, significantly higher than the 15 million reported in November and 5 million in May. In addition to this, Netflix’s ad revenues are forecast to jump 50% next year to top $1 billion, with Disney+ topping the $1 billion ad revenue mark in 2025. Over 80% of ad revenues will stem from CTV, with the remainder from PC and mobile.
We will be looking for more management commentary in the earnings call regarding expectations for 2024.
Source: Beth’s Twitter
Revenue and EPS
The company’s Q3 2023 revenue grew by 7.8% and 8% YoY in constant currency to $8.5 billion, helped by the membership growth from cutting off passwords. This was the highest growth rate in five quarters. This is an acceleration QoQ from the 2.7% growth and 6% on a CC basis last quarter.
Q4 is also expected to accelerate with management guiding for Q4 revenue of $8.7 billion for growth of 11% and 12% on a CC basis. This will be an acceleration in both QoQ (to be expected due to seasonality) and year-over-year with 10% growth reported on a CC basis in the year ago quarter.
Netflix’s revenue growth is expected to trend upward through the June quarter, which is currently marking peak revenue growth for NFLX per analyst consensus at 15.4%. It will then soften to 13.7% in the September quarter, become slightly stronger in the December quarter at 14%, before settling in the 10% range for 2025.
GAAP EPS came in at $3.73 and beat the analyst consensus estimates by 6.7%. Management guide for the next quarter is $2.15.
EPS is a bright spot for Netflix with FY2024 expected to grow 30% — this will be stronger than 2023’s growth of 23%. For FY2025, EPS is expected to grow 22%.
Margins
The highlight with margins is the expanding operating margin.
The Q3 gross margin was 42.3% compared to 39.6% in the same quarter last year and 42.9% in the previous quarter.
The operating margin came in at 22.4% compared to 19.3% in the same quarter last year and 22.3% in the previous quarter. Despite a guide for 13.3% in Q4, the fiscal year is expected to report 20%. Management expects further improvement to 22% to 23% for FY24. The operating margin has been seasonally low in the Dec quarter and the Dec guide is up from 7% last year.
Net margin was 19.6% compared to 17.6% in the same period last year and 18.2% in the previous quarter. The management guide for next quarter is 11% and is up from 0.7% in the same quarter last year.
Cash Flow and Balance Sheet:
The company’s cash flows were a highlight of the Q3 report. The operating cash flow came in at $1.992 billion, representing a cash flow margin of 23.3% compared to 7% in the same period last year and 17.6% in the previous quarter.
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 and 16.4% in the previous quarter.
Management increased its FY23 free cash flow guide to $6.5 billion from the earlier $5 billion. When adjusted for the roughly $1 billion from the writers and actors strikes, it comes to $5.5 billion. The management expects to deliver substantial free cash flow in 2024 despite the expected increase of cash content spending in 2024.
As per CFO Spence Neumann in the Q3 earnings call, “So first, in the letter, we talk about the 2024, we hope to get cash content spend back up to at or near that $17 billion level (up from the expected $13 billion in 2023).
The biggest swing factor is going to be when the SAG-AFTRA strike resolves. And so that will get us to a cash to P&L ratio kind of closer to 1:1.1x. And so we're not putting a specific number out there for free cash flow in 2024. What that gets us to, when you think about the combination of our revenue growth outlook, our margin guidance and target cash content spend, we'll deliver substantial free cash flow in 2024. And then going beyond that, we do expect to tick up our content investment over time as we also prove at sustained healthy revenue growth.”we'll deliver substantial free cash flow in 2024. And then going beyond that, we do expect to tick up our content investment over time as we also prove at sustained healthy revenue growth.”
The company has cash & short-term investments of $8 billion and debt of $14 billion. The company returned the excess cash over the minimum cash level through a stock repurchase of $2.5 billion in the quarter and also increased the share repurchase authorization by $10 billion.
Key Metrics
Netflix reported 8.76 million in paid net additions for a total of 247.15 million paid memberships, representing YoY growth of 10.8%. This is the highest number of paid net additions in recent quarters.
Analyst consensus was between 6.5 million and 6.9 million and this was also significantly higher than the management guide of 5.89 million. Per management, this was due to: “the roll out of paid sharing, strong, steady programming and the ongoing expansion of streaming globally"
Management expects paid net additions similar to Q3 of 8.76M, and the expected paid membership growth will be 10.9% YoY to 255.91 million. TD Cowen expects paid net additions of 9.03 million, bringing the paid memberships growth to 11%, reflecting seasonality and a strong slate of Originals in the quarter. The firm's consumer survey shows Netflix remains the top choice for living room viewing.
Regions:
Average revenue per membership (ARM):
- Across the regions, ARM in APAC had the most significant 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 Q3.
Paid Net Additions:
- All regions added paid net additions. United States added 1.75M up from 1.17M in the previous quarter. This segment is watched closely.
- EMEA added the most paid net additions at 3.95M.
- The management mentioned in the Q3 shareholder letter that the “Global ARM in Q4 is expected to be roughly flat year-over-year, primarily due to limited price increases over the last eighteen months.” However, with the price increase announced during Q3 results, we could see ARM resume growth going forward.
Per our last write-up, ARM is something to watch: “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.
What to Watch For:
Last quarter, there was outsized pressure on margin commentary. In the Q3 post-earnings update, we discussed the clarity given by the CFO following the confusion from his commentary at the Bank of America conference in September. You can read more background on this here (main takeaway is that it’s been resolved).
In the Q3 earnings call, he said, “We understood that investors were – they've been pretty patient with us, so we wanted to demonstrate the scalability and the health of the business model. And so that took us from – it was like 4% OI margin to operating income margin business in 2016 to our current roughly 20% margin. So we think a pretty good indicator that ad scale streaming can be a quite good business. Now stepping back, there's no change in our financial objectives and also no change in our long-term margin expectations, including the fact that we see a – and we don't think we're anywhere near a margin ceiling. We've got a long runway of margin growth.And so that took us from – it was like 4% OI margin to operating income margin business in 2016 to our current roughly 20% margin. So we think a pretty good indicator that ad scale streaming can be a quite good business. Now stepping back, there's no change in our financial objectives and also no change in our long-term margin expectations, including the fact that we see a – and we don't think we're anywhere near a margin ceiling. We've got a long runway of margin growth.
So again, no change in our objectives, no change in our long-term margin expectations. But our current profitability and scale, we think it's prudent to balance that historical pace of margin improvement with growth investments. So you asked about growth investments. We think we've got a lot of places where we can continue to invest, plenty of room to invest further in our existing content categories, we're a small share of viewing in every country in which we operate. Plus building out those ads capabilities that Greg talked about our live offering and new content categories like games. So there's plenty to do.”we think it's prudent to balance that historical pace of margin improvement with growth investments. So you asked about growth investments. We think we've got a lot of places where we can continue to invest, plenty of room to invest further in our existing content categories, we're a small share of viewing in every country in which we operate. Plus building out those ads capabilities that Greg talked about our live offering and new content categories like games. So there's plenty to do.”
Conclusion
Netflix’s performance has shown its ability to adapt and innovate, overcoming past challenges and capitalizing on new opportunities. The strong cash flows, accelerating revenue, improving margins, and subscriber growth show that the company has delivered on its promise to shareholders. This has been especially important given the change in management, from the Street favorite, Reed Hastings, to a more collective approach of two CEOs.
One thing we are on the lookout for is if the ad tier’s initial adoption will begin to slow and/or if Netflix will run out of growth levers. This may be more of a concern for 2025. With that said, an ad tier should greatly improve margins as we go along and that’s also central to the story beyond paid net additions.
As always, there is a lot to consider and we will keep you in the loop on how we view Netflix’s inevitable slowing growth come 2025 (or perhaps 2026) in the face of its impressive and expanding margins.
Look for our post-ER report after hours on Tuesday!
Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.
Recommended Reading: