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Industry Consolidation and Internal Initiatives Will Support Subscriber growth

MI
MichaelPNot Invested
Content Lead

Published

August 30 2023

Updated

November 29 2024

Narratives are currently in beta

Announcement on 29 November, 2024

Continued Solid Member and Revenue Growth, Plus Cost Controls - Upgrading my Valuation.

Overall, Netflix had another solid quarter, and is tracking slightly ahead of my estimates. Revenue growth, member growth and margins are tracking better than I expected, while cost controls are largely in line with my estimates.

My original narrative was over a year old, so I have rebased my valuation to be a new 5 year estimate, and this has increased my fair value estimate from $627 to $797.

Assumption 1: Subscriber growth will continue at 10% per year

Same as last quarter, Netflix is outperforming my expectations for this assumption.

The company had subscriber growth of 14.4% YoY, still ahead of my 10% estimate. This means they added 5.07m members to reach 282.72m paid memberships. If this growth rate continued, it would reach around 553m subscribers by September 2029. As mentioned last quarter, I may be wrong, but I believe that kind of growth rate will be hard to sustain.

I originally estimated 10% growth in members per year. If we continue that 10% annual growth rate from today (282m subs), that would be 454m subscribers by September of 2029, which is 20% higher than my prior 380m estimate for late 2028.

As mentioned last quarter, I still think the strong growth will slow down as the initial benefits of the paid sharing and ad-plans rollout subsides. But that doesn’t mean it won’t be able to achieve a higher ARPM by that time due to higher Ad revenue and price increases, which I think it will.

Considering this is the 2nd last quarter where they will be disclosing ARPM and subscriber numbers, it will be hard to accurately assess these metrics in 5 years time (unless they pass a milestone, in which case, they’ll announce it).

So while this won’t be my primary metric going forward, I estimate that Netflix will reach 454m paying subs by September 2029 (10% p.a. growth).

Assumption 2: ARPM To Rise at 5% per year, and revenue to grow at 13%

Like last quarter, I am currently underestimating this one, since revenue and ARPM are growing faster than expected.

Revenue of $9.825bn for the quarter from 282m subscribers is $34.8 in revenue per member for the quarter. If we annualize this, we get $139.3, which is $11.6 per month. Global ARPM last quarter was $11.5/month, so this has been mostly flat.

Revenue grew 15% YoY which was slightly ahead of my 13% estimate. The ads business is still scaling well with 35% growth in memberships quarter on quarter. It’s ad tech platform is on track to launch in Canada in Q4, and more broadly in 2025. The out-performance in terms of revenue can be attributed to adding more members than I expected.

The thing is, the ads plan so far has only started rolling out to the US, Australia and Brazil. The US and Australia have higher ARPM than the rest of Netflix’s markets (countries in APAC, LATAM and EMEA)

When it starts expanding into other regions around the world, where its existing ARPM is lower, I imagine it won’t be able to charge as much in these regions for the ad plans as it does in more developed regions. So despite the ads plans have strong adoption from users, I still believe ARPM will drop in the near term when ads are rolled out more broadly.

With this being the case, and having just rebased my narrative, I believe that ARPM will decline in the short term, and rise, on average, by 2% per year over the next 5 years (down from my prior 5% estimate). That means I estimate it will reach $153 per year by September 2029, leading to $69.67bn in overall revenue from the 454m subs.

Assumption 3: Content Costs And Operating Expenses To Stabilise

This assumption is largely on track. The expense of “Additions to content assets” totalled $4.016bn this quarter, the same as last quarter, and higher than Q3 last year at $3.5bn. On an annualized basis, that's still only $16bn, below their guidance of $17bn.

The company guided to roughly $17bn run rate of content spend per year, and seems to be managing with even less than that, at least for this past quarter.

Even if they do start increasing this spend at 5% as I originally expected, the revenue growth should continue to outpace this content spend growth, and therefore its % of revenue should continue to stay around 40%, and net margins should increase.

The Cost of Revenue expense (primarily the amortisation of content spend, plus acquisition, licensing and production of content) was 52% of revenue, down from 57% for 2023, and 61% in 2022. As revenue grows at a faster rate than their content spend as they scale, I expect this % to continue to reduce.

As for the operating expenses (Technology & Development, Marketing and General & Admin), these expenses have remained relatively steady as a % of revenue. T&D has stayed at 6.5% of revenue this quarter. Marketing is down from 7.6% to 6.5% this quarter, while General and Admin declined, from 4.9% a year ago to 4.2% now.

These have almost all reduced past my initial estimates of 7%, 7% and 4% of revenues by 2028, respectively. Management could either choose to increase there spend here given the strong revenue growth, or I will have to increase my net margin estimate slightly in a few quarters if they don’t.

All these efficiency improvements from more scale and operational leverage are flowing through to the bottom line, which leads me to my next assumption.

Assumption 4: Profit Margins To Expand from 13% to 20%

This assumption is largely on track, and slightly better than I expected.

I originally assumed that net profit margins would increase from 13% to 20% by 2028. But for Q3 already they’re sitting at 20.7% on a TTM basis, and 24% for the quarter.

This is really encouraging to see, and shows that the continued steady revenue growth, aligned with cost discipline is all flowing through to the bottom line and quicker than I anticipated. 

As mentioned last quarter, if the company seems likely to reach 25% net margins by year-end, which they’re anticipating. Based on management commentary, and improving operational efficiency, it seems likely to achieve operating margins around 30%. I believe that my profit margin estimates of 20% by 2029 may be too conservative. So I’m going to increase my net margin estimates from 20% to 25%, given NFLX’s net income seems to be around 85% of operating income (income before interest and taxes).

With this in mind, that this changes my FV quite a bit. If I assume 25% net income margins on $69bn in revenue, that delivers $17.25bn in earnings in 2029, instead of my original $10.56bn earnings estimate for 2028. With a 30x PE on $17bn in earnings, this would be a $517bn market cap in 2029. Dividend by 427m in shares outstanding, this equates to $1,210 per share. Discounted back at 8%, per year, that means my new FV estimate is $797 per share.

Overall, the business is still performing very well, and on track or ahead of my estimates. My conviction in the business has grown as I’ve watched it and got to know it better. It’s just unfortunate that the market has come to appreciate its strength faster than I have, meaning I’ve been slightly underestimating it’s potential over the last few years.

Key Takeaways

  • Possible consolidation in the streaming market will benefit NFLX with better negotiating leverage
  • Internal initiatives of ad-plans and paid sharing will drive user and revenue growth
  • ARPM will increase due to future price increases and advertising revenue
  • Advertising dollars will transition from Cable TV to NFLX as its ad-supported members base grows
  • Discipline on content costs will increase net margins and push future earnings and cash flows higher

Catalysts

Industry Catalysts

Consolidation Of Content In The Streaming Market

After 25 years of expensive growth, Netflix has now become the most dominant, profitable streaming player in the world. With 238m subscribers, trailing 12 month revenues of $32bn and cash flows of $4.6bn (all as of June 30 2023), the company has reached scale economics that allow the streaming model to work profitably.

The last 5-10 years has seen a huge increase in competition in the streaming space, but these competitors are yet to reach that elusive scale economies in their DTC (direct-to-consumer) offerings that Netflix has now achieved.

The likes of Amazon has 200m prime subscribers, Disney+ has 146m, Warner Bros has 96m subscribers across its Max and Discovery offerings, Paramount+ has 61m, and AppleTV+ reportedly has an estimated 25m-40m paid subscribers (hard to get an exact figure, and its services business has 1bn subscribers, which includes the Apple One subscription with access to AppleTV).

While we don’t have exact figures on subscriber count from the non-pure play streamers (Amazon, Apple), they, along with Disney, appear to be using these services as loss-leaders to provide value to users in their ecosystem of other offerings and can fund these loss-making DTC ventures with money from other parts of their businesses, with the hopes that users spend more elsewhere in their respective ecosystems.

However, the more pure-play media businesses, like Warner Brothers (WBD) and Paramount (PARA) don’t have as much scale as these other businesses and would require much larger subscriber count for their DTC offerings to be viable long-term (i.e. profitable).

While NFLX, WBD and PARA have similar total revenues of $32bn, $41bn and $29bn respectively, they have very different FCF (Free Cash Flow) margins of 13%, 7.5% and -3.9% respectively.

Also, that’s WBD and PARA’s total revenues, their annual DTC revenues (12 months to June 30 2023) are much lower at $9.9bn and $5.8bn respectively, so much smaller than Netflix, and less profitable as well (WBD DTC offering generated a loss of $745m for the 6 months to June 30 2023, and Paramount’s DTC generated a loss of $935m for the same period).

I think there is a greater chance than not, where due to the lack of profitable scale from their DTC offerings, these smaller streaming players may consider re-leasing more of their content library back to the likes of bigger streamers to generate a good return on the content and IP. We’re already seeing some of this occur.

Smaller streaming platforms will likely realise there’s no point in owning great content and IP if you can’t monetise it profitably with your own smaller streaming platforms. So Netflix now holds the leverage over smaller content owners who don’t have the same scale.

If that’s the case, I believe Netflix could be in a position to negotiate much better prices for the content, since it has the upper hand in negotiations now with its size.

Netflix will likely be the one who has the deepest pockets and can afford it sustainably, but it won’t be ludicrously high prices for Netflix on a relative basis, simply due to the fact that it can divide that cost among a wider subscriber base.

I believe this will take a few years to play out, but will ultimately increase Netflix’s user count, and justify charging more revenue per user based on the wider variety of desirable content available, which is currently sitting on smaller platforms.

 

Streaming To Continue Rising As A Percentage Of Total Viewing Time

For years, we have continued to see streaming growing as a % of viewing time. And 78% of American households now subscribe to at least one or more streaming service.

According to Nielson, time spent streaming reached 34.8% in 2022, surpassing cable (34.4%) for the first time in history, and more than broadcasting at 21.6%.

And it seems like the transition away from expensive pay TV is set to continue.

Source: MNTN Research

As the trend of “cord-cutting” continues, and the amount of “cord-never” households continues to grow, this will likely be a tailwind for streaming companies, especially Netflix, due to its vast on-demand content library and much better value proposition.

A report from MNTN Research indicates just how unappealing Cable (Linear) TV is.

  • It found that the average US consumer pays $1,600 per YEAR for cable channels they don’t even watch.
  • Of the 190 channels on offer, they only watch 15, meanwhile, the cost of cable has increased 52% over the last 3 years.
  • And 4 out of 5 users wish they could just pay for the channels they watch.

Former VP of Product, Gibson Biddle put it simply where he discussed the phrase “Consumer Science”:

I found that consumer science — the scientific method of forming hypotheses, then testing them — is the best way to build a culture of customer obsession and to discover what delights customers in hard-to-copy, margin-enhancing ways.

From my observations of other companies that focus on delighting customers, they typically underperform financially in the early days while they build up their scale, but in the long run, they end up building themselves a moat with delighted loyal users. Whereas those businesses that don’t put customer delight first tend to watch their strategies backfire in the longer term as they rest on their laurels and lose their competitive edge and revenue as a result.

As long as existing cable/linear offerings continue to price gouge for poor value propositions and streamers like Netflix continue to focus on delighting customers in a margin-enhancing and affordable way, I believe this will be a tailwind for user adoption and retention of streaming platforms globally, but particularly Netflix.

Company Catalysts

Ad-plans Should Decrease Churn And Increase Revenues (Eventually)

Netflix’s ad-supported plans have the potential to decrease churn, increase subscriber count, increase ARPM (Average Revenue Per Member) and thus, increase revenues. Here’s why.

Firstly, the basic plan in the UK and US has been replaced by the ad-supported plan for new subscribers. The basic plan was $9.99 per month (without ads) and the new ad-supported plan is 30% cheaper at $6.99 per month.

According to a report from Antenna, churn among the streaming industry has increased from 4.7% in July 2022, to 6% in July 2023. However, there was one company that wasn’t affected: Netflix. It actually saw a slight decrease in churn.

Churn rates among streamers: Yahoo! Finance

I’d attribute this to:

  1. The password crackdown initiative (also called “paid sharing”)
  2. Adding ad-supported plans
  3. Netflix’s growing base of original content
  4. High engagement levels (engagement levels 3 times higher than peers combined)
  5. The broad range of content, globally

Many streaming businesses were seeing increased churn in 2022 due to cost of living pressures, amongst other challengers.

The reason I believe these ad plans could decrease churn is because they have the potential to “catch” at least a portion of users who would have otherwise churned without a lower-priced offering. Given the cost of living challenges that have continued into 2023, I imagine that some users may opt to reduce their plans from the standard $15.49 per month to the $6.99 plan in an effort to reduce costs while retaining access to the platform.

Additionally, those more cost-conscious users who have been considering a Netflix account but have been turned off by the price, are more likely to opt-in at the lower price point plans now that they’re 30% cheaper than before.

As of May 2023, at just 6 months old, the ad-supported plans had roughly 5 million Monthly Active Users (MAUs), with a median age of 34, and on average, more than 25% of new Netflix sign-ups chose the ad-supported plans (in countries where it is available).

Building a Forever Business - Netflix Upfront 2023

Ad Plans To Decrease ARPM, Then Increase It In The Longer Term

As for the Ad plans increasing ARPM, I believe this is a longer-term story, where we likely see ARPM actually decline in the short term for three reasons (explained below), before recovering longer term.

  • Firstly I believe Ad-supported plans will increase as a percentage of total subscribers in the short to medium term, which currently generate less revenue than the Standard and Premium plans.
  • Secondly, I believe most of Netflix’s user growth will come from international markets, which are offered at lower price points than the bigger and more mature markets like the US, etc.
  • Lastly, I believe that as the password crackdown (paid sharing) initiative is rolled out, those users who have been “free-loading” will sign up as additional users to those existing plans (at a cost of $7.99 per month) rather than sign up to a new standard or premium plan themselves. Data from Antenna indicated the paid sharing plan started well.

Image Source: DemandSage

These 3 reasons would see ARPM drop in the medium term, but then as the advertising plans pick up steam, the revenue generated per ad plan could surpass the previous basic plans ($9.99) due to the $6.99 price plus whatever ad revenue it generates, therefore increase ARPM.

According to EDO, Inc. (a leading TV outcomes measurement platform used to measure the immediate impact of ads across linear and streaming), Netflix ad-supported viewers are more than:

  • “4x+ as likely to engage with an ad on Netflix than other streaming services; and 
  • 4.5x+ as likely to engage with an ad on Netflix than linear TV.”

From an advertiser's point of view, these higher engagement metrics make at least trying out Netflix a more appealing proposition than continuing to advertise on linear TV or other streaming services.

While the ad supporter subscriber count is still only small now, giving big advertisers little reach, it will likely only attract smaller advertisers with smaller budgets for now.

But eventually, as uptake of the ad-supported plans increases, and advertisers get access to bigger audiences, I believe revenue generated from the advertising dollars will likely exceed the discount that these ad-supported plans offered users (30% cheaper than the original basic plan), and therefore, increase ARPM longer term.

 

Benefits of Scale Are Finally Kicking In

Now that Netflix has reached a scale where it can take its foot off the pedal in terms of content cost growth, it is becoming more profitable.

Its content spending increased from $1.75bn in 2012, to $16.7bn in 2022, a 25% annual growth rate, which virtually matches its revenue growth rate for that period as well (from $3.6bn to $31.6bn).

Netflix Content Spend: Statista 2023

Now though, Netflix management (the CFO) has stated it is past the most cash-intensive part of building out its original programming (page 12 of earnings transcript). Meaning, that content cost will grow at a much slower rate than it has historically.

With management's new focus on disciplined growth in operating expenses, and content cost spend, I believe more of each additional dollar of revenue will flow through as profit to the bottom line.

With the new focus on profitability, this cash flow will either be reinvested into only high ROI opportunities and whatever is left over from that will used to pay down debt or distributed to shareholders, likely in the form of buybacks.

Assumptions

Subscriber Growth Will Continue

Netflix subscriber count has grown at an annual rate of 22% per year from 2012 to 2023, but I don’t expect this will continue. Based on my catalysts above, I assume that user growth will continue at a rate of around 10% per year because, despite its good growth prospects, I believe the high user growth days are behind it. Therefore I expect it to reach 348m subscribers by 2028.

 

ARPM To Eventually Rise, Adding To Revenue Growth

According to FourWeekMBA, Netflix’s ARPM in 2022 was $141 per year, or $11.75 per month, up from $95 per year ($7.91 per month) back in 2015 (5.8% growth per year).

As mentioned, I expect the ARPM to decrease in the short term as the ad plans gain momentum, as user growth in the international market accounts for most new user growth, and as “paid sharing” is rolled out. But I think expect ARPM to increase in the longer term based on incremental price increases, and increasing advertising revenue on ad plans.

NFLX Average Revenue Per Member (ARPM) across regions: FourWeekMBA

With this short-term decrease and long-term increase in mind, I expect ARPM to increase at an average of 2% per year for the next 5 years, to reach $152 per subscriber ($12.7 per month).

With the subscriber count estimate of 348m, this would equal $52.8bn in revenue by 2028.

Content Costs And Operating Expenses To Stabilise

Based on management's comments, I expect content costs to grow at only around 5% per year, for the next few years, much lower than its 25% historical growth rate. So while they are $16.7bn for 2022, I expect content costs to reach $21.3bn in 2028. This would be 40% of revenue, rather than the current 52% of revenue as it stands today.

As for the other expenses (Technology & Development, Marketing and General & Admin), I expect management will keep investing in technology to improve the user experience and delight them on the different platforms the service is available on. As for marketing, I expect they will continue growing marketing spend to acquire new users in their newer markets. And as for G&A, I expect it will grow slowly based on management's new disciplined approach to expenses. While these will all increase in terms of dollar value, I believe they will decrease a % of revenues, thanks to the operating leverage mentioned earlier.

Therefore, I estimate T&D to be about 7% of 2028 revenues (or $3.6bn, up from $2.7bn in 2022), marketing spend to be around 7% of revenues (also $3.6bn, up from $2.5bn in 2022), and G&A to decrease to 4% of revenues (or $2.1bn, up from $1.5bn in 2022).

Profit Margins To Expand

As for the company’s net profit margins, I expect them to slightly increase based on the solid revenue growth tied in with better control of expenses. Net profit margins are currently 13%, and I expect them to reach 20% by 2028. This would imply earnings of $10.56bn in that year based on the $52.8bn in revenue.

Risks

Actors and Writers Guild Strikes Could Pressure Margins

If you’d like a breakdown of the ongoing strikes, this video from Vox provides a great explanation, as well as these sources (1,2,3,4). While it seems like Network TV and most American-focused production companies are facing the biggest risks in the short term in terms of stalled production, Netflix may be less impacted in the short term but is not immune.

Netflix may have a bit of a buffer because it has international content production capabilities and a solid pipeline of content produced, but further down the line, there is a chance that the strikes may result in higher costs per production in the future. While this would no doubt be great for the actors and writers to get more fairly compensated for their work, it would mean potentially lower margins for each production.

 

Intense Competition Globally

The global entertainment industry is highly competitive with various economic models capturing meaningful segments of the market. Additionally, different markets have different preferences and styles. While traditional providers of video entertainment are generally facing tough headwinds, and we appear to be saturated with streaming offers, these all still pose a threat to Netflix.

If Netflix has any missteps in regards to its global expansion, production execution or user experience, there’s a chance users could start gravitating towards competitors for their entertainment needs. Based on Netflix’s competitive advantages of scale, and IP, I don’t believe this is likely, but it’s worth acknowledging and watching trends in non-US market user growth, original content production streams and competitor's offerings to be on top of this.

 

Execution Risk on New Initiatives Is High

As Netflix expands internationally and develops new features on its service like games, advertising plans, paid-sharing, etc., the execution risk and complexity within the business grows.

If the company slips up in any of these areas, there is a chance that investors will re-value the company lower, since it appears to have high expectations of solid execution in these areas of late.

Only a year ago, investors were incredibly pessimistic about Netflix and its prospects, valuing it at 18x earnings, and now it’s at 44x earnings, so a lot can change in less than 12 months. I believe the company can execute long term, and therefore don’t view these as high-likelihood risks, but they need to be monitored in case it becomes apparent that the narrative isn’t unfolding as expected.

Also, IF the market does re-rate the company lower, and nothing has changed in terms of the long-term narrative above, that could present the perfect buying opportunity, which admittedly I passed up on in 2022.

How well do narratives help inform your perspective?

Disclaimer

Simply Wall St analyst MichaelP holds no position in NasdaqGS:NFLX. Simply Wall St has no position in the company(s) mentioned. This narrative is general in nature and explores scenarios and estimates created by the author. These scenarios are not indicative of the company's future performance and are exploratory in the ideas they cover. The fair value estimate's are estimations only, and does not constitute a recommendation to buy or sell any stock, and they do not take account of your objectives, or your financial situation. Note that the author's analysis may not factor in the latest price-sensitive company announcements or qualitative material.

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Fair Value
US$797.7
16.0% overvalued intrinsic discount
MichaelP's Fair Value
Future estimation in
PastFuture010b20b30b40b50b60b20132016201920222024202520282029Revenue US$60.5bEarnings US$15.1b
% p.a.
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Current revenue growth rate
10.11%
Entertainment revenue growth rate
0.35%