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:

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

Industry Consolidation and Internal Initiatives Will Support Subscriber growth

Shared on29 Nov 24Fair value Increased 7.15%

Shared on29 Nov 24
Fair value Increased 7.15%