Netflix: A Change in Posture
In this post, I’ll discuss the quarter, the change in reporting, Netflix’s million dollar question, management’s evasiveness on paid sharing and what inning we really might be in, and what seems to be a material change in management’s posture.
Netflix’s first-quarter results were great. The business added 9.3 million paid net adds, bringing ending paid memberships to 269.9 million. That’s 37.1 million paid net adds over the last 12 months, the highest of any 12-month stretch other than the one ending June 30, 2020 during peak COVID. Netflix is benefiting from monetizing paid sharing via sub growth and extra members, the lower priced ad tier, and perhaps more time since the pandemic pull-forward of subscribers.
Average revenue per member grew 1% but grew 4% excluding changes in foreign exchange rates. Overall revenue grew 14.8% but 18% excluding changes in fx. That is yet another revenue growth acceleration given the business grew 2.7%, 7.8%, and 12.5% over the previous three quarters, respectively, and 6%, 8%, and 13% respectively, excluding changes in fx.
Netflix’s margin expansion was particularly impressive. Content amortization grew just 6.1% year-over-year while other cost of revenue actually fell 2.8%, which caused total cost of revenue to grow just 3.6%. Total cost of revenue was 53.1% of revenue, an all-time low. The operating leverage that’s enabled by Netflix’s fixed cost content in conjunction with that content’s ability to drive revenue globally across borders continues to pay off. I think many investors may nod their heads about this but may not fully think through the implications for the company’s long-term margins or, more likely, simply don’t care because it is far beyond their investment time horizon.
The business also levered tech & dev and G&A expenses while losing a smidge on marketing. Overall operating margin expanded a whopping 710 bps year-over-year to hit 28.1%, an all-time high. Incremental operating margin was 76.0% in the quarter. And 2Q guidance of a 26.6% operating margin implies a 53.1% incremental operating margin. I view the 50%-60% range as where Netflix’s operating margins are probably heading over the long term based on what I think are reasonable assumptions. But again, whether one cares about that is a function of their expected holding period and whether they are pricing stocks—essentially guessing what others will pay for them sometime soon—or valuing them—what they might be intrinsically worth based on the discounted stream of future cash flows.
Change in Reporting
The bit of controversy in this report was management’s plans to stop disclosing paid memberships and ARM after the first quarter of 2025. Despite a stellar quarter and strong guidance, the stock declined 9% the day after earnings almost certainly for this reason.
It is pretty clear that management has long been somewhat frustrated by the market’s obsession with quarterly paid net adds and the stock’s volatility around that metric. It is also clear that last year’s move to stop giving paid net add guidance was part of a longer term plan and the stepping stone towards dropping the quarterly disclosure all together. Of course, management’s reasoning—that not all subscriber growth is created equal so the KPI has therefore lost its meaning—is specious. Why? Well, that’s been true for as long as they’ve had different plan tiers and international streaming. The company has disclosed subs and ARM by region since 2017, which I think has been an effective and helpful disclosure allowing investors to understand the relative value of each region’s sub growth.
My best guess is management expects sub growth to slow in 2025 or 2026 and wants to avoid a repeat situation where the stock market overreacts like it did in 2022 when the stock tanked 75%. By only reporting revenue, management can probably pull the ARM lever by pulling sub-levers like subscription pricing, ad-tier monetization via CPMs or ad loads, and perhaps increasing monetization of extra members. So even if sub growth slows in 2025 or 2026, maybe ARM can pick up most of the slack by growing faster such that overall revenue can still grow at healthy double-digit rates. Investors wouldn’t be any wiser and would have no reason to overreact to slowing sub growth—which is inevitable and should be fully expected over time.
The Million Dollar Question
The million dollar question with Netflix is…
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