Netflix: The Streaming Wars That Never Started

Netflix reported its fourth-quarter results last week. Here’s the shareholder letter.

Netflix is back to firing on all cylinders. I won’t rehash the whole quarter, but the company just added 13.1 million paid net adds—the second-most after the first quarter of 2020—grew revenue 12.5% year-over-year (13% in constant currency terms), expanded its operating margin almost 10% year-over-year, generated $1.6 billion of cash, and bought back $2.5 billion of stock at an average price of $456.40 in the quarter.

For the full year, Netflix added 29.5 million paid net adds—the second-most ever after 2020—grew revenue 9% in constant currency, expanded operating margin 2.8% year-over-year, generated $6.9 billion of cash, and bought back $6.0 billion of stock at an average price of $416.51 per share.

More people are now acknowledging that Netflix won the “streaming wars,” but that implies the streaming wars ever happened. It was more of a cold war that never turned hot. In fact, the opposition gave up before it started and began selling its weapons back to Netflix. What’s surprising is that this is a surprise at all. When you have $30+ billion of streaming revenue, enabling the funding of $17 billion of cash content spending, which drives far more subscriber engagement than anyone else, which drives pricing power that no one else has, which drives even more revenue with which to reinvest in more content and technology to continuously make the service better, how was anyone else going to put up a serious fight? They didn’t and they were never going to despite their best efforts.

Simply put, establishing a growing, profitable streaming service with the world at your fingertips is really hard when Netflix already exists. It doesn’t matter who has a larger percentage of high-brow “quality” content. It doesn’t matter what 20-year-old IP you might have in your vault. What truly drives engagement and therefore streaming success is an absolutely massive firehose of new content across genres and geographies. And no one but Netflix can economically justify buying the firehose.

That is very unlikely to change. Competitive streaming services have been raising prices, removing content, and licensing once-exclusive content to Netflix in an effort to make their economics work. But each of those moves makes their consumer value propositions worse. They might reach profitability but then what? Simply put, it’s much harder to grow when you raise prices and make your offering worse. Their hope is no one will notice. But stranger things® have happened than losing customers who experience deteriorating value propositions. I’m not predicting that but it’s possible.

On the other hand, Netflix is going from strength to strength. The new ad tier while still small grew members 70% quarter-over-quarter in the fourth quarter after growing 70% and 100% sequentially in the two prior quarters, respectively. It now has 23 million MAUs and is now attracting 40% of new sign ups. It also monetizes better than the Standard plan and far higher than Netflix’s overall average revenue per member (“ARM”). That’s why management is starting to eliminate the Basic ad-free tier all together in some markets to either nudge those members into the cheaper but higher monetizing ad tier or the higher monetizing ad-free tiers. As Netflix grows ad tier MAUs and ad inventory slots, Netflix will become increasingly attractive from an advertiser perspective. We just learned that Netflix signed a 10-year deal with WWE for live programming and other content, which will create even more ad inventory. Beyond that, improved ad targeting, measurement, and possibly differentiated ads that improve engagement are coming.

Paid sharing has successfully grown subscribers and ARM through extra members. While management said they have now finished “operationalizing” paid sharing, those gains are not over. This has been a gradual rollout. I know people personally who are still sharing for free who haven’t been forced to make a change yet.

As for guidance, management expects double-digit revenue growth on a constant currency basis this year driven by member growth and constant-currency ARM growth due to price increases. Operating margin guidance for this year was raised from 22%-23% to 24% compared to 20.6% last year—340 bps of margin expansion. First-quarter guidance calls for 13% revenue growth or 16% on a constant currency basis. Free cash flow is expected to be another $6 billion, down a little as cash content spending is expected to jump $3-$4 billion versus last year. Although, Netflix typically comes in somewhat light of its cash content spending guidance, which if true again, would imply more than $6 billion of free cash flow this year. That will almost certainly grow in 2025 given further revenue growth and operating leverage that comes largely as a result of fixed cost content.

So What’s Next?

Netflix is going to continue running its global playbook. There are over 500 million connected TV households globally and an estimated 600 million to 700 million broadband households. Neither are static figures. With slow and steady household growth over the long term and broadband penetration rates continuing to rise around the world, there should be around 2 billion global households ex-China in 20 years and perhaps 1.7-1.8 billion broadband households. That assumes a 99% broadband penetration rate in UCAN and 85% in EMEA, LATAM, and APAC. And I assume there is no meaningful distinction between CTV households and broadband households in the fullness of time.

Given Netflix has just 260 million global members, there is still a massive global runway ahead. And what competitive offering is going to stand in their way? That ship sailed long ago. Competitors have all thrown in the towel on catching up with Netflix and now seem content if they can just manage a sustainable streaming businesses.

Netflix’s long-term pricing story is just as exciting as the member growth story. Netflix captures only 7.7% of U.S. TV screen time in more established markets like the U.S. but this is while linear still exists. Streaming is only 36% of total screen time.

As linear shrinks and goes away over the long term, streaming will become virtually all of screen time. And if Netflix were to hold its current share of streaming flat—possibly a conservative assumption given the favorable competitive dynamics that are playing out—it would capture more than 21% of total screen time. Consumers pay more for what they value more, and they value more what they use more. That is why management is discusses engagement, engagement, engagement so much while its competitors don’t.

Given U.S. ARM is $16-$17 today, what will it be when we are watching (and playing!) Netflix 3x as much? What about 4x or 5x? What if management eventually figures out how to license live sports economically and/or live news just like it eventually changed its tune about advertising or cracking down on password sharing? U.S. households were willing to pay well over $100—sometimes over $200—per month for a linear TV cable package. I certainly don’t predict Netflix will charge that much in my forecast period, but there is a huge pricing umbrella for them to grow into over time, especially as they increase the content offering and grow engagement. On top of that, ad-free pricing should benefit from a tailwind as the ad tier continues to improve monetization. For example, the lowest monetizing Basic ad-free tier going away puts upward pressure on ARM. Eventually, the same could happen with the Standard tier or its price will rise enough to keep it on par with ad tier monetization. So big picture, over the long term, the subscriber base might double or triple but ARM can probably do so as well.

Licensed Content

On the call, there was a question about whether management might be shifting its mix of content a bit back towards licensing now that its competitors are more willing to license content to Netflix.

Ted’s line that I highlighted above is something I had been thinking about. Out of necessity, the competition is now more willing to license content to Netflix. But Netflix doesn’t need or want to license everything. Theoretically, motivated sellers plus, I won’t say an unmotivated buyer, but a buyer that can be choosy should cause downward pressure on the cost of some of this licensed content. So it may be that ~$17 billion of cash content spending in 2024 gets Netflix 10% more content than $17 billion of cash content spending did in 2021 or 2022. I’ve also thought this about Netflix’s leverage with the sports leagues as it relates to their docuseries projects. Given the tremendous value that F-1 and others receive from the exposure on Netflix, one could argue that the leagues should be paying Netflix. Even if it doesn’t go that far, the tremendous value the leagues derive from being on the Netflix platform in front of 260 million households and probably 1 billion or more people should put downward pressure on Netflix’s content costs. So I would argue that if even if a smaller competitor was somehow willing to spend $17 billion of cash on content this year, it probably wouldn’t get as much content as Netflix gets. As if Netflix wasn’t competitively advantaged enough already.

Hit Content

There was a time when Netflix was struggling after it ran into a growth wall in 2022 and before it had ramped up advertising and paid sharing. One prominent analyst claimed Netflix’s problem was it wasn’t putting out enough hit content. I disagreed with this. Season 4 of Stranger Things was a massive hit yet Netflix actually lost subs in UCAN during that period. I felt that even hit content wasn’t moving the needle because Netflix had meaningfully saturated its market when considering and including the 100 million global households who were sharing a password. It’s hard to grow paid subs with hit content when people simply don’t have to pay. And those people who sign up and cancel just to watch hit content are exactly the same people who are most likely to share a password and not pay.

Now that paid sharing has been rolled out, although not entirely yet, I am interested to see if there is any difference to the impact of hit content. When season 5 of Stranger Things comes out and you can no longer share a password, shouldn’t that show up more in paid net adds than it has in the past? I would think so but we’ll see.

Correcting the Record

After seeing a lot of streaming services struggle and hemorrhage cash, a lot of people have said things like “streaming isn’t a good business.” Anyone paying attention to Netflix would know not to make a blanket statement like this. The truth is “streaming” can be a great business if one has unprecedented global scale and industry-leading engagement. If you don’t have that, streaming might very well be a tough business.

Here is Ted and Greg not-so-subtly pointing this out in this quarter’s letter.

Capital Allocation

At first, I didn’t love Spencer’s answer on the call about how they don’t try to time stock buybacks, but instead conduct more of a steady buying or price averaging approach. They have said this before so this isn’t new, but I’m going to comment anyway.

Theoretically, a CFO would value the stock and buy more shares at a larger discount to intrinsic value and fewer shares at a smaller discount. That’s how to maximize value creation through share repurchase. That said, it can be hard even for insiders to predict what’s a good price. Management bought back $600 million worth of stock in 2021 at an average price of $507 per share. Within a year, the stock fell 76% from its high to just $166 per share when Netflix suddenly hit its growth wall. Not even insiders saw that coming.

So a steady price averaging approach is certainly not the end of the world. Plus, my partnership is only a shareholder because I think the stock price is trading at a large discount to what it is likely worth. So if buybacks are occurring while I’m a shareholder, I should also believe they are occurring only at attractive prices.

Scenario Analysis and Valuation

I’ll save this and the financial discussion for my next post. As usual, I’ll provide six different potential long-term scenarios for Netflix with explicit assumptions and value the stock in each scenario. One of them is a reverse DCF, which simply uses assumptions necessary to back into the current stock price. Obviously, the assumptions required to back into $565 stock price are rosier than the ones I used in November to back into a $434 stock price. But I’ll present the data and leave it up to you to decide what makes sense.

Disclosure: Long NFLX

Disclaimer: 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.