Netflix: Welcoming the Arms Dealers
Netflix reported its third-quarter results on October 18th. Here is the shareholder letter.
I thought this was a fantastic start to the letter:
Revenue grew 8% year-over-year as reported and in constant currency terms. That was due to the 9% year-over-year gain in average paid memberships and the 1% decrease in ARM (“average revenue per member”), which was the result of growth in lower-ARM countries, limited price increases, and some shift in plan mix.
As for guidance, management expects accelerating revenue growth into the fourth quarter with guidance of 11% growth or 12% on a constant currency basis. The quarter should have a similar number of paid net adds—9 million—plus or minus a few million, and ARM should be flattish.
Essentially, Netflix is benefiting from the gradual rollout of paid sharing whereby password borrowers who want to continue watching Netflix must either transfer to their own new paid accounts or become a paid extra member on the original account. This boosts both the paid subscriber base through new accounts as well as ARM through extra members. They are carefully rolling it out in cohorts so they can measure results and tweak the experience as needed to maximize results. Management expects to see the benefits of this for several quarters to come.
Meanwhile, the writer’s strike is delaying content spending. Cash content spending will be about $13 billion this year, down from $16.7 billion last year, which is helping to boost near-term cash flow. Content amortization is tracking towards $13 or $14 billion as well, which is flat to down slightly from last year. When revenues are growing and content amortization, the single largest expense, is flat to down, margins increase. That’s part of why we’re seeing operating income and free cash flow surge this year. Netflix is on track to generate $6.6 billion of operating income and $6.5 billion of free cash flow this year.
As for the ad tier, it is just getting started but is coming along nicely with 70% quarter-over-quarter growth and a 30% mix of new sign ups in countries that offer the ad tier. The key for Netflix’s advertising business is scale. The more eyeballs are watching, the more attractive Netflix is as a place for advertising dollars. And this is a $180 billion ad market for linear/connected TV, excluding China and Russia. It feels inevitable to me that Netflix will have meaningful ad revenues in the long run.
To get there, management wants to nudge more subscribers towards the $6.99 ad tier. That’s why they stopped offering the Basic ad-free tier to new sign ups and partially why they just raised the price of the Basic ad-free tier to existing subscribers. New customers in the U.S. are offered the $6.99 ad-tier, the $15.49 Standard ad-free tier, and $22.99 Premium ad-free tier. Clearly, they are widening the gap between the $6.99 ad-tier and everything else to drive more people into the ad tier. And in the shareholder letter, management suggested an “even wider” range.
Recall management said the $6.99 ad tier was already monetizing better than the $15.49 Standard tier several months ago, so trade down is already nicely accretive. I believe the ad tier monetization will continue to improve and will eventually monetize comparably or better to the Premium tier, if it isn’t already. That should give management more freedom to raise ad-free prices because any potential trade down to the ad tier is accretive. I think that is behind the “even wider” comment.
Big Picture
It was always a bull case for Netflix that competitive streamers would come around to the realization that streaming on a smaller scale with less robust engagement metrics is a very difficult business. And that they would eventually shift more of their business back to arms dealer mode by licensing content to Netflix. After all, licensing revenue is virtually all profit, which can look tempting compared to burning billions of dollars of shareholders’ money on streaming.
For a while there as Disney+, HBO Max, and others were ramping up and seeing decent subscriber growth, there wasn’t much talk of this. At the time, I thought it was more likely than not at some point, but I assumed it might take 3-5 years or maybe longer before this might potentially play out. Well, it’s been happening and began sooner than I had expected.
It wasn’t that long ago when all the talk was about how Netflix was screwed because its competitors were pulling content in favor of their own streaming services. Shows like The Office and Friends were pulled and put on Peacock and HBO Max (now known as Max), respectively. Netflix would no longer benefit from its competitors’ content. And because “content is king,” Netflix was doomed.