Growth Stocks: Netflix

Netflix (NFLX.US) has experienced explosive growth in its paid subscriptions, with an annual increase of over 20% from its launch until the fiscal year 2020. However, starting from the fiscal year 2021, growth has slowed to single-digit figures, suggesting that the company may be reaching saturation in key markets such as North America and Europe. To drive future growth, Netflix is focusing on monetizing its existing subscribers.

Despite the initial heavy investments in streaming content, Netflix has shifted its focus and now aims to maintain its content spending more steadily to ensure the satisfaction of its current subscribers. According to a discounted cash flow model, the current stock price of Netflix is slightly overvalued, indicating limited short-term growth potential.

Additionally, the report highlights that Netflix has implemented measures to address password sharing and has introduced a lower-tier plan with ads to reach additional customer segments at a lower price. Despite the slowdown in subscription growth, these strategies, coupled with stability in content spending, are expected to contribute to maintaining Netflix's dominant position in the streaming industry and offer upside potential in the future. However, the analysis suggests that growth may not be immediate, and the current stock price reflects a slightly elevated valuation.

Post-Explosive Growth Landscape

Paid subscriptions for Netflix increased by 20% in fiscal year 2019 and 21.9% in fiscal year 2020 but started moderating, reaching 8.9% in fiscal year 2021 and 4% in fiscal year 2022. Meanwhile, the average monthly revenues per paid subscription grew by only 0.8% in fiscal year 2022, compared to the 9.5% growth in fiscal year 2017 and 9.3% in fiscal year 2018.

source: Netflix 10-k

In the fiscal years 2019 and 2020, Netflix's paid subscriptions experienced growth of 20% and 21.9%, respectively. However, this trend has moderated, reaching 8.9% in fiscal year 2021 and 4% in fiscal year 2022. Simultaneously, the increase in average monthly revenues per subscription was only 0.8% in fiscal year 2022, compared to the growths of 9.5% in 2017 and 9.3% in 2018.

Netflix's period of explosive growth seems to have come to an end, facing challenges to continue gaining market share in a saturated streaming landscape. Despite being a pioneer in streaming, competition has intensified with the arrival of platforms like Hulu, Disney+ (DIS.US), YouTube TV (GOOG.US), HBO Max, Peacock TV, and Paramount Plus.

Moreover, the pandemic led to a temporary surge in Netflix subscriptions as many people started working from home. However, analysts suggest that the company likely reached its peak potential customers during this period and will struggle to significantly increase subscriptions as people return to the office in the post-pandemic era.

In the first quarter of 2023, Similarweb Insights reports that Netflix has lost market share in the United States, decreasing to 44.21%, while services like HBO Max and Peacock TV have gained ground during the same period. This growing competition and the potential market saturation pose significant challenges for Netflix's future growth.

Similarweb Insights

Netflix's Strategies: Ad-Tier and Password Sharing Crackdown

In late 2022, Netflix introduced its "Basic with Ads" plan, a lower-priced option supported by advertising, aimed at reaching a broader audience. Priced at only $6.99 per month in the United States, this Ad-Tier is expected to attract new subscribers, and the combined revenue model of subscriptions plus ads could generate profit margins similar to their regular streaming services. The Basic with Ads version is positioned as a more affordable choice for low-income families and infrequent content consumers.

Netflix, leveraging its advanced data analytics capabilities, strategically integrates ads into its streaming services while maintaining profit margins similar to its standard offerings. Additionally, the platform has taken steps to address password sharing, a phenomenon affecting 33% of Netflix accounts, according to Leichtman Research Group data. The company is gradually implementing measures to tackle this issue in most countries of operation, recognizing that the transition from shared accounts to individual subscriptions may take 3 to 6 months or more.

The action against password sharing is presented as a strategy to maximize Netflix's benefits. While some shared users might opt for individual subscriptions immediately, others may not. Nevertheless, this measure is expected to drive Netflix's revenue growth and increase its subscriber base, marking a positive step for the company's future.

Turning 100 Million Non-Paying Viewers into Paying Subscribers

Netflix's decision to address password sharing arises from the need to convert non-paying viewers into paying subscribers. Over 100 million people accessed Netflix content without contributing to the company's revenue, presenting an opportunity for significant long-term growth. It is estimated that about 41% of Netflix users consume the service without paying, either by sharing passwords or accounts, and approximately 52.5% share their passwords with other households.

The implementation of measures that simplify account and subscription management has allowed Netflix to mitigate the risk of widespread cancellations. The initial response from members to the crackdown on password sharing has been moderate, with few reports of significant increases in cancellations. This indicates that members understand and accept the need for these measures, resulting in an increase in paid subscriptions and higher retention rates.

As Netflix expands these measures to over 100 countries, covering over 80% of its revenue base, the company is poised to capture potential paying subscribers. The crackdown on password sharing not only encourages individual accounts but also recognizes the importance of catering to additional household members. Offering price levels with and without ads provides options for users, and a slight shift toward ad-free subscriptions is expected among derivative accounts.

It is crucial to highlight that the implementation of measures against password sharing is a gradual process, not a one-time event. Netflix has adopted a phased approach, achieving significant net paid subscriptions in the second quarter of 2023, attributed to the successful launch of shared payment. This gradual implementation allows the company to adjust its strategy and adapt to member behavior, marking a positive step for future growth.

source: 99 Firms

Combinated Strategy: The Power of Advertising at its best

source: Statista, font Netflix

One unexpected effect of cracking down on password sharing is the improvement in member retention at Netflix. New subscribers attracted by this measure tend to be long-time viewers on the platform, exhibiting retention behaviors similar to more tenured subscribers. This phenomenon translates into a more stable subscriber base, reducing churn and ensuring a steady flow of revenue for the streaming platform.

Additionally, Netflix has implemented pricing adjustments to cater to diverse consumer preferences. The elimination of the basic plan in some countries, such as Canada, the United States, and the United Kingdom, with attractive prices ($5.99, $6.99, and £4.99, respectively), offers options including ads, ad-free, video quality, and simultaneous streams. These changes have been well-received, providing excellent value to consumers in these markets and increasing the Average Revenue per Member (ARM). As more subscribers opt for higher-priced plans, it directly impacts Netflix's overall revenue.

While the impact of cracking down on password sharing may not be immediately evident in revenue growth, the gradual nature of its implementation will contribute to a sustained increase in paid memberships over time. Netflix has emphasized that their initial focus with this measure is to boost paid memberships, deferring the impact on ARM for later. They expect revenues and earnings per share (EPS) to accelerate in the coming years, with a full annual impact expected in 2024.

In addition to cracking down on password sharing, Netflix is venturing into the advertising market. Although in its early stages, this strategy could significantly contribute to long-term revenue growth by leveraging the platform's extensive user data and viewing habits. This diversification aims to reduce dependence on subscription fees and provide additional avenues for revenue growth, acting as a potential buffer against market saturation.

In summary, Netflix's strategy, combining the crackdown on password sharing with pricing adjustments and entry into advertising, targets sustainable long-term growth. Improvements in member retention, price increases, and expansion into new revenue models position Netflix to maintain its dominance in the streaming industry and offer promising prospects for investors.

Content Spending Cap Exceeded

In the last two years, Netflix has allocated around $17 billion annually to its content budget, and it is expected that this spending will remain at similar levels until the fiscal year 2024. This investment represents approximately 56% of its total revenues. The consistent focus on the content budget is strategic, as Netflix recognizes the importance of high-quality content to maintain customer satisfaction and prevent subscription cancellation rates.

From a financial perspective, maintaining a steady content budget has the potential to improve the operating margin and increase free cash flow generation, which is particularly appealing to investors. In the second quarter of the fiscal year 2023, Netflix experienced a year-on-year revenue growth of 2.7% and an 8% increase in streaming paid subscriptions globally. Additionally, they generated $1.34 billion in free cash flow in this quarter, marking a significant improvement compared to the same period last year.

Source: Netflix 10-k

Despite a debt of $14.5 billion, Netflix's balance sheet is considered robust, with a gross debt ratio of less than 1x. Additionally, they have $3.4 billion in capacity under their $5 billion share repurchase authorization. The company's management has indicated that they anticipate a substantial improvement in free cash flow in the fiscal year 2024, suggesting optimization of their content spending and a positive outlook for the coming years.

Key Risks

The primary concern for Netflix lies in the highly competitive streaming landscape, facing traditional giants like Disney, Comcast, Paramount, and Warner Bros., as well as tech companies like Apple, Amazon, and Alphabet's YouTube. The lack of customer loyalty and the ease of switching between services highlight the importance for Netflix to consistently provide high-quality content, exceptional customer service, and competitive pricing to retain its subscriber base. Market saturation and limitations on subscriber growth in mature markets pose challenges for maintaining the same level of revenue growth that has historically propelled the company.

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Source: Netflix

Furthermore, the Hollywood writers' strike has caused significant delays in content creation, which could impact Netflix's content spending and cash flow, leading to potential irregularities in the upcoming quarters. Although Netflix's management has acknowledged this potential impact, the company finds itself in a challenging position in an ever-evolving market.

Conclusions

While Netflix may not sustain double-digit revenue and subscription growth in the coming years, it stands out for its consistent focus on content spending, which could result in margin expansion and increased free cash flow generation. The implementation of strategies such as Ads-tier and password crackdown is expected to create growth opportunities, although the stock price is slightly overvalued, leading to a 'Hold' rating for Netflix.

In conclusion, Netflix's aggressive strategy in password sharing crackdown has the potential to be a game-changer, allowing the platform to accelerate sustained growth by addressing non-paying user bases and diversifying into the advertising market. Although the impact may not be immediate, the gradual implementation is expected to reinforce long-term revenue and valuation. With improvements in member retention and pricing adjustments, Netflix is well-positioned to maintain its dominance in the streaming industry, offering investors promising upside potential.

The company will announce its results on October 18th at the close of the Wall Street session.

Darío García, EFA
XTB Spain