Netflix: To the Victor Go the Spoils

Netflix won, peers are retrenching, the runway is huge, and the stock is cheap.

Netflix reported its first-quarter results on Tuesday. Here’s Ted and Greg’s shareholder letter and the transcript, both of which I think are must-reads.

For context, this is the first quarter without Reed as co-CEO but you wouldn’t know it by the vibe of the letter or the answers on the earnings call. Management’s tone and message were of the same flavor that I’ve gotten used to over the years with Reed in charge as CEO or co-CEO. That shouldn’t be surprising because these three have been running the business together for some time.

As for the quarter itself, there wasn’t much surprising. Revenue was as expected, margins were a bit better, and free cash flow of $2.1 billion is starting to ramp. I could go through all the metrics for these 90 days but frankly, whether revenue growth or margins came in 100 bps better or worse than expected or quarterly EPS beat or missed is really not that relevant for long-term shareholders. What is relevant are any new data points or learnings that provide greater clarity or confidence into the extent to which Netflix can live up to its long-term potential as the global SVOD leader and how that will translate into free cash flow over time. From that perspective, here is what I found important.

Early Paid Sharing Results

The first-quarter launch of paid sharing in four countries, including Canada, seems like a promising leading indicator for the broader rollout in the U.S. and elsewhere that’s now been pushed back to the second-quarter. As expected, paid sharing generates an initial cancel response as it is effectively a price increase. That played out in Canada but as sharers signed up for their own accounts or signed on as “extra members,” things improved. Paid memberships, not counting extra members, and revenue now exceed pre-paid sharing rollout levels. And Canadian revenue growth has accelerated and now exceeds U.S. revenue growth. What seems like a 2-3 month delay in the broader paid sharing rollout should enable further tweaks and improvements to the process that should benefit the business. That seems well worth the brief delay.

Basic with Ads Monetization

Basic with Ads (“BWA”) is already monetizing better than the $15.49 Standard plan in the U.S. This is great but not very surprising to me. For context, there had been fear that the lower priced ad tier would drive meaningful trade-down from Standard and Premium subs. But like I wrote about in Netflix: Some Ad-Supported Math (July 2022), I thought the ad tier was poised to monetize really well given 1) the strong monetization of competitive ad-supported tiers and 2) Netflix’s relative superiority on some of the key variables: engagement, ad load, CPM, and subscription price.

Given BWA is monetizing better than $15.49 and the subscription price is $6.99 in the U.S., that means the monthly ad revenue per member must be more than $8.50. But it’s probably not monetizing better than the $19.99 Premium tier yet or one would think they would have said that. Therefore, total monetization is probably between $15.50 and $19.99 per month, which means the ad piece of it would be between $8.51 and $13.00.

That seems really good considering BWA only launched in November—and getting into the ad business at all was only put in motion a year ago. And it should only increase as they improve targeting, measurement, and all the rest of it. I’ve said this before, but the speed at which Netflix executed on the ads launch is simply remarkable. That speed reminds me of Peloton CEO and former Netflix CFO Barry McCarthy’s comment last year that it would take months for Peloton to address its tech debt so it could A/B test on its website while that would have taken Netflix “1.5 days, even early on.” Netflix is simply world-class when it comes to execution at speed.

Given the excellent BWA monetization, management is actually making the offering better to encourage both new sign ups and a potential mix shift from other plans to BWA. It is boosting BWA video quality from 720p to 1080p and increasing concurrent steams from one to two. In fact, 1080p and two concurrent streams makes the BWA feature set equivalent to Standard but with ads. BWA is effectively becoming SWA for only $6.99 per month. If you’re a Standard sub paying $15.49, are you at all tempted to switch? Maybe the investor class reading a blog called Implied Expectations won’t be tempted, but there should be some trade down among the masses. Remember when investors worried about trade down not that long ago? Shareholders should be praying for it.

We can start with the $8.50 to $13.00 of ad monetization per user to then try to solve for the underlying variables of engagement, ad load, CPM, subscription price, and for the first time, the unknown level of leakage to advertising partners, notably Microsoft. Obviously, Netflix and Microsoft do not disclose the terms of their partnership.

First, in 2019 former VP of Original Content Cindy Holland said the average Netflix subscriber watches Netflix two hours per day. However, that was before several competitive streaming launches so it’s likely somewhat lower than that today. After all, if that were still the case today despite the increased competition, I assume Netflix would have been eager to disclose it. For now, I’m penciling in…