Scale, Operating Leverage And Ad Plans Will Drive EPS Growth

Key Takeaways

• Netflix ad-supported plans will drive new revenue
• Revenue per user will decrease in short term from ad plans, but increase longer term
• Margins will continue to improve as costs grow slower than revenue (operating leverage)
• User growth expected from password sharing crackdown
• I believe these 3 catalysts will result in $52bn in revenue and $12.5bn profit by 2028

Catalysts

Industry Catalysts

There is Room For More Than One Streaming Platform

The video streaming industry has become very competitive, and the market has been hyper focused on the question of “who will win the streaming war.” I don’t think this is a winner takes all situation, and there is room for a handful of platforms. There are pros and cons to each platform and many households end up subscribing to two or three platforms. 

Market Share in the streaming space as at Dec 2022 - Source : JustWatch

In North America the bigger challenge has been the fact that it has already saturated the market. This means subscriber growth will be limited, but there is room for some gains with plans at lower price points (see below)

There is however room for a lot of growth elsewhere, and particularly in Asia. In addition, Netflix has been very successful developing local content like Squid Games in South Korea. This content gives the platform an edge in the markets with lower penetration. Again, lower price points will help it grow the subscriber base in these markets.

Netflix Historical Subscriber count to Q3 2022 - Source: Statista

Company Catalysts

The Crackdown on Password Sharing will Deliver Modest Gains

Over the last six months, Netflix stopped allowing subscribers to share passwords in all its markets. It estimated that 100 million people were consuming content with another subscriber’s password. 

The company is now allowing subscribers to add additional users for an additional, reduced monthly fee. Netflix expects ~70% of the 100 million ‘password bandits’ to become paying subs within three years, with those subs split between full subscriptions and reduced fee add-on users.

I’m less optimistic than that, as there will also be some attrition. Nevertheless I believe there will be net gains of 15%+ of those 100 million per year over the next three years. However, many of those subs will be on the additional user tier, so overall ARPU will likely decline. Using global metrics and assuming 50% are add-on users paying 50%, that works out to about 15 million new subs at an average of $8.80 APRU.

 

The Next Big Opportunity for Netflix: Ad Revenue and Lower Price Points

I believe ad revenue will be the new growth driver for Netflix over the next 5 to 10 years. As consumers move from linear networks (cable, satellite etc) advertisers are being forced to reach them and they want cost-effective solutions. And linear networks aren’t as accurate as digital advertising methods.  

Ads on streaming services can also be targeted to specific consumers based on demographic data and viewing patterns, in the same way that ads are targeted on social networks. Targeted ads are measurable and have a higher ROI as they are only shown to a target audience, unlike ads on linear networks. 

This is the reason that the most profitable ad platforms are Meta (Facebook and Instagram), Google (Search and Youtube) and Amazon - generating more than $400 billion in sales between their respective ad businesses in 2022. 

With its vast content library and relatively high subscription prices, Netflix is now ready to capitalize on this opportunity. Consumers will have a choice between ad free viewing at a premium rate, or discounted subs if they are prepared to have their favorite shows interrupted by ads.

Expected share of Netflix subscribers using the ad-supported tier worldwide from 2023 to 2027 - Source: Statista

The company is taking a very measured approach to rolling out ad supported plans. There are several trade-offs to consider as it works out the price points that maximize total revenue from premium subs, discounted subs and ad revenue. Netflix has always focussed on the long term rather than on smoothing out its earnings from one quarter to the next.

It’s likely that the ad supported plans will result in declining average revenue per subscriber in the near term. Not only are the ad supported tiers priced at less than 50% of the standard tier, but some subscribers may downgrade to this cheaper plan. 

However, in the long term, rising ad revenue will result in ARPU rising once again. As more consumers sign up to ad supported plans, more advertisers will join the platform. Rising demand will lead to higher revenue per subscriber and increasing subscriber numbers will lead to more overall revenue.

I do think the advertising business will take a few years to gain traction, so ARPU may decline faster than subscriber numbers rise for two to three years. However, when ARPU begins to accelerate again there should be a period of sustained revenue growth. This would likely result in a period of multiple expansion (growing PE ratio) around 2027 to 2028.

 

Operating Leverage Works its Magic as Scale Pays Off

Netflix’s content budget increased rapidly at ~35% a year between 2012 and 2019. Since then it has grown at less than 5% a year, and the company has indicated that it will follow a similar trajectory going forward. This is still a very large budget which will allow the company to add a substantial amount of content to its already substantial library of original content. 

The company has also learnt a lot about producing and funding content over the last 15 years, which means it will be able to optimize its content spending. Put simply, Netflix can do a lot with a budget of $20 odd billion and doesn’t need to try to outspend its competitors.

Likewise, operating expenses (OpEx) will not need to increase at the same rate as revenue. OpEx has already declined from around 25% of revenue to around 21% over the past five years. I expect this trend to continue.

Netflix Revenue and Operating Cash Flow - Source: Simply Wall St

As free cash flow increases, borrowing will decline and the interest expense will decline. The company will also be able to continue to repurchase shares resulting in a lower share count.

The deceleration of content spend and expenses mean that even low double digit revenue growth will result in rapidly increasing net income and EPS as more of each new dollar flows to the bottom line.

Assumptions

I think that Netflix is incredibly well positioned for the next 10 years. However, these assumptions are for the period through 2028 as there are too many variables for assumptions beyond that to be meaningful. It is possible that the outlook will be a lot brighter when the advertising business begins to contribute meaningfully. 

Average Revenue per User Will Decline and Then Begin to Increase as Ad Revenue Grows

I believe Global ARPU will decline by 15-20% over the next two years, but then begin to rise again as ad revenue increases. I’m forecasting ARPU of $10.10 in 2028, which is 14% below 2022 levels.

Subscriber Growth Will Continue at Low Double Digit Rates

I believe global subscriber numbers will increase at 11% a year through 2028 with North America increasing at 5%, EMEA and Latin America increasing at 10% and Asia increasing at 20%. Netflix will therefore have 430 million subscribers paying an average of $10.10/month in 2028 ($12.20 per year), and therefore earn revenue of $52 billion.

Operational Leverage Will Result in Rapid Growth In Operating Profits

I’m forecasting modest increases in content costs of 5% a year through 2028 to $25.8 billion. I believe operating expenses will decrease from the current level of 21.5% of revenue to 18% by the end of 2028, which will be $9.4 billion. This will result in an operating profit of $16.4 billion in 2028.

 

Lower Interest Expense and Share Buybacks Will Also Contribute to EPS Growth

With higher free cash flow, Netflix will make less use of debt, so I’m forecasting an interest margin of 6% of operating profits in 2028, compared to 11.5% for 2022.  

I’m assuming a tax margin of 16% of operating profit. This would leave $12.8 billion in net income for FY2028, and therefore a net profit margin of 25%.

I’m also anticipating Netflix buying back 1% of outstanding shares each year, in which case there will be 419 million outstanding shares by the end of  2028, compared to 444m today.

Risks

• In the medium term it's possible that revenue and earnings dip if ARPU declines faster than the subscriber base grows. While I expect APRU and subscribers to decline, I believe it will only be short term and these trends will reverse in 2-3 years. 
• The catalysts above assume that Netflix will be able to keep producing content that is good enough to keep subscribers on the platform and attract new subscribers. If the quality of new content deteriorates noticeably compared to other platforms, Netflix will lose subscribers. However I do not believe there is a high likelihood of this happening.
• Competitors (Disney and Amazon in particular) may decide to spend whatever it takes to win customers away from Netflix. This could happen in the form of lower subscription fees, higher content spending or offering other incentives.