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 “How much revenue can they support with how much content spending?” No one knows exactly. They expect to spend “up to $17 billion” of cash on content this year, but it will probably fall somewhat short of that given their m.o. They also spent $17.5 billion in 2021. So what’s changed since then? Well, revenue has grown from $29.7 billion that year to an estimated $39 billion this year. So 31% revenue growth with cash content spending flat to down. Not a bad model. How far can it go?

Given that I think there’s still a long way to go monetizing paid sharing, the ad-tier is still tiny and severely undermonetized, and there are hundreds of millions of global households to monetize over the long term, it seems like a foregone conclusion that Netflix can support substantially more revenue with the same level of content spending. That said, content spending should still increase over time but I don’t think it will even remotely keep pace with revenue growth. That will be by far the largest driver of margin expansion over time.

Paid Sharing

Management is cagey almost to the point of absurdity on the topic of what inning they are in monetizing the 100+ million households that were watching for free. Greg Peter’s efforts to avoid giving a substantive answer has been something to behold.

Here is his answer on the fourth-quarter call where he introduced this “operationalized” buzz word management clearly came up with and agreed to use:

And here he is on the first-quarter call:

So many words without even coming close to providing a real answer. CFO Spence Neumann also dropped management’s agreed-upon buzz word at the Morgan Stanley conference in March:

So why are they being so evasive on this topic? I have a theory. There is still a long way to go. But they don’t mind us thinking it is mostly over and their growth is mostly about thrilling their members with a great slate. Consider this part of the call where the question was phrased to suggest paid sharing is mostly over.

Ted does not disabuse him of that idea, I think, because they are just fine with us thinking that. Why? Well, if it’s actually far from over then that could mean they might have something like 50 million or 60 million or more password sharing households left to monetize in their back pocket. They can choose to monetize them at their discretion. We know this is a management team that has always disliked the focus on quarterly paid net adds and the resulting quarterly stock price volatility. That’s why they are dropping quarterly sub and ARM disclosures. A management team motivated to do that would probably not mind having 50 or 60+ million households in their back pocket to monetize as needed to smooth out the quarterly volatility they seek to minimize. If a quarter is off to a slow start, maybe they can monetize a bit more to still achieve a healthy pace of growth. If the quarter is off to a fast start, maybe they can monetize less or perhaps none at all to save more for a rainy day.

So Which Paid Sharing Inning Are We Really In?

Recall it was first-quarter 2022 earnings when management first disclosed that over 100 million plus households, including over 30 million in UCAN, were watching for free using a paying member’s password. At the time, there were 221.6 million paid memberships globally, including 74.6 million in UCAN. Today, there are 269.6 million globally, including 82.7 million in UCAN. That means there have been 48.0 million paid net adds since then, including 8.1 million in UCAN.

It seems unlikely that Netflix is done monetizing the password sharing opportunity, at least in UCAN. This was a pretty slowly growing segment before paid sharing and the ad tier came around. Netflix added 1.3 million and lost 0.9 million paid memberships in 2021 and 2022, respectively, before the paid sharing rollout started in the first quarter of 2023.

Let’s say Netflix would have added 1 million paid subs in UCAN in the 12 months since then just organically without paid sharing. After all, they are really limited here with sub growth when 105 million or more households, including password sharers, were already watching. That would be 80%+ broadband household penetration in UCAN when including those 30+ million password sharers.

So if they would have added 1 million anyway, that implies they gained 7.1 million from paid sharing, which is obviously a small fraction of the 30+ million household opportunity. Of course, some of those have been monetized by becoming extra members. We don’t know how that breaks down, but let’s say for lack of better data there’s a 50/50 split between which path the successfully monetized password sharer goes down. (If you have better information, please let me know.) If that were the case, then 7.1 million have been monetized via new memberships and 7.1 million have been monetized via becoming an extra member. That’s 14.2 million out of a 30+ million opportunity, making Netflix in perhaps the 4th inning of paid sharing monetization in UCAN.

Obviously, to the extent the 50/50 split assumption is wrong, the conclusion would change. But the split would have to be about 24/76 in favor of extra members for Netflix to have already monetized 30 million UCAN password sharers (7.1m/30m = .237). And that seems very unlikely because we would see that sort of extra member growth show up in UCAN ARM—22.9m extra members monetizing at $7.99 per month would add $549 million to quarterly revenue. That’s simply not possible given UCAN revenue only grew $616 million year-over-year, which was explained by 7.0 million more average members and 6.9% ARM growth, which itself was largely driven by the U.S. 20% Basic and 15% Premium price increase implemented in the fourth quarter of last year. There does not appear to be room in the quarter’s revenue for there to have been a huge impact from extra members in UCAN.

As for ex-UCAN, I think estimating this gets more complicated. The lower priced ad tiers and the under-penetrated nature of most of these markets makes it harder to guess what underlying organic sub growth would have been without the benefits of paid sharing. Because with that greater white space, there are probably more households who sign up directly into the ad tier.

Maybe Netflix would have gained 15m-20m subs in the ex-UCAN regions without paid sharing. So maybe 20m-25m of the 39.9m actual ex-UCAN sub growth could be attributed to paid sharing. Throw in another 10m for extra members. From eye-balling the year-over-year ARM growth, it does not seem obvious that there are super meaningful gains from extra members yet—EMEA ARM growth ex-fx was 0%, APAC was -4%, and LATAM was 16% but juiced by aggressive price increases in Argentina. Yes, there is an ARM headwind from new spun off memberships into lower priced plans, but there have been price increases in the U.K. and France late last year. Either way, it does not seem clear that extra member gains are material. In any case, that would be 30m-35m of the 70m+ who have been monetized, so maybe ex-UCAN is in the 4th inning as well. But that is a pretty wild guess.

Anyone have better information, logic, or reasoning? I’d love to hear it.

Capital Allocation Philosophy

A few comments on this. First, this language from the shareholder letter stood out.

What jumps out at you from that paragraph?

For me, the word “currently” jumps off the page. By including that word, it implies that there may be a time when they do have plans to lever up and buy back stock. Otherwise, why include the word? That seems material—like cracking the door open to something they have long resisted.

I also thought it was interesting they took the effort to amend the terms of their $1 billion revolving credit facility on March 6th, but then terminated and replaced it only weeks later with a new $3 billion facility. Did something change between March 6th and April? Also, the original $1 billion facility was entirely undrawn. It seems somewhat unlikely they had plans to terminate it and upsize it only weeks later. Here’s the language from the 10-Q:

That brings me to a final observation. The language in the Liquidity and Capital Resources section of this quarter’s 10-Q:

When I read that, I did not recall that language in prior filings so I checked. Sure enough, this is new. Last year’s 10-K and prior 10-Qs, use this language:

That does seem like a material change in posture, does it not? The lawyers only change the language in these filings when they need to.

My guess is management knows free cash flow is going to increasingly gush in the coming years. They are already reinvesting in the business as much as they want to given that’s always been their first priority. They culturally prefer build over buy in terms of M&A so that is unlikely to be a material use of cash. The most likely and realistic remaining use of cash is a material increase in share repurchase. Their investment grade rating has allowed them to move off the “holding two months of revenue in cash” positioning and get more efficient with capital. And they left the door open by inserting the otherwise unnecessary word “currently” into whether they had plans to lever up and buy back stock.

Connecting the dots, if I’m right that Netflix still has a huge amount of paid sharing left to monetize in their back pocket as needed, it suggests that they now have much more control over their reported numbers than they used to. It’s possible this—and eliminating the sub/ARM disclosure in 2025—could help them reduce the (downside) volatility of their reported results. That seems to have been management’s desire for a long time. And if they reduce the downside volatility of reported results, it seems like they might consistently beat expectations for a while.

A management team that knows that would probably feel pretty comfortable buying back stock. Oh look, that’s interesting, they are suddenly more flexible as it relates to capital efficiency and taking on additional debt yet they have no obvious use for it other than share repurchase. And they are already buying back material amounts of stock—$2+ billion per quarter—but don’t “currently” have a plan to lever up and accelerate it. Hmm. It will be interesting to see what happens.

Disclosure: Long NFLX

Disclaimer: This post is for entertainment purposes only and is not a recommendation to buy or sell any security. Everything I write could be completely wrong and the stock I’m writing about could go to $0. Rely entirely on your own research and investment judgement.