Netflix: Removing The Ceiling

From “The Cost Of Success”: “[The FCF inflection is] validation of the strategy that Netflix pursued over the past 10 - 15 years. They’ve established a dominant global leadership position in this industry, and it is now showing up in a big way… The investment to get there was substantial; that was the cost of success. My view for some time has been that the legacy media companies are unlikely to replicate that outcome, which will present additional opportunities for Netflix… This course of events has taken longer to play out than I once believed it would, but I think the end game is unchanged.”

In Q3 FY23, Netflix reported 11% YoY paid subscriber growth. This return to double digit volume growth, an outcome that some may have said they’d never achieve again if you had asked them 12-18 months ago, is a testament to the clarity of Netflix’s long-term strategic vision, its sustainable competitive advantages, and the tailwinds of structural change in the media industry (despite some blips along the way). As we approach the end of 2023, it’s worth taking a step back to frame where Netflix stands: they will exit the year with more than 250 million paid subscribers globally. Those members pay the company ~$11.5 per month, on average, to access a massive library of content across every vertical of entertainment programming (something for everybody in the household). Those subscribers are the foundation for a business that generates ~$35 billion in annual revenues and ~$7 billion in annual operating income (run rate). And yet, despite all that Netflix has accomplished over the past decade, the movie is just getting underway; as we look to the future, I believe massive opportunities remain for Netflix.

Subscribers

CFO Spencer Neumann (Q3 FY22 call): “Now that we have an account sharing solution, we have a clearer path to more deeply penetrate that growing addressable market of 500 million connected TV households.”

In “Heads Down And Execute”, I wrote the following on UCAN growth: “The likely outcome here is that volume growth, which hasn’t been a material contributor to UCAN revenue gains for the past three years, could return to low-single digit or mid-single digit annualized growth (I think we could be in for some surprises on how high this number can go over 2-3 years).”

That second comment (“over 2-3 years”) was based on a few factors: (1) the size of the UCAN market, with ~140 million households; (2) Netflix’s attractive consumer value proposition, which is becoming more finely tuned to meet the needs of different customer segments; (3) the likely (large) amount of sharing underway given the company’s strategy over the past 5-10 years (which, as I’ve argued, really encouraged Family plans / password sharing); and (4) the pace of the crackdown, with reason to believe it was slowly implemented.

It's still early, but we’re starting to see a notable change in the trajectory: UCAN added 1.75 million net paid subs in Q3 FY23, it’s highest sequential gain in 18 quarters (excluding the pandemic tailwind in Q1 FY20 and Q2 FY20). Over the past six months, UCAN has added 2.9 million net paid subs, compared to 4.4 million over the previous three years (Q1 FY20 to Q1 FY23).

These figures provide early evidence on the password sharing crackdown: when forced to decide, many sharers will conclude Netflix is worth paying for. As management noted on the Q3 call, this accelerated growth has come despite a measured pace on the rollout of the password sharing crackdown: “We’ve always thought this change should be done in a steady, considered way… As a result, there are a number of borrower cohorts, which as of today, have not received [the paid sharing crackdown notice]… We're going to continue the roll out for the next couple of quarters… we anticipate that we will have incremental net adds for the next several quarters.”

As we look ahead, what’s a realistic target for Netflix paid subscribers in UCAN and globally? In the U.S., pay-TV penetration peaked at roughly 90%. If Netflix can execute against the (significant) technical challenges associated with effectively policing password sharing, while adeptly segmenting the plan structures to serve various customer needs, I do not see clear impediments to ~100 million UCAN subs, or ~70% household penetration, over time. (For what it’s worth, management used to discuss a long-term U.S. opportunity of 60 - 90 million subs.) That outcome assumes Netflix will continue to cement its leadership position in the DTC VOD industry, while also taking advantage of disruption - as an example, by licensing content from competitors who are quickly realizing they do not have the ability or willingness to stay in this fight.

As we look globally, we can start with the aforementioned ~500 million CTV households (which excludes a few notable markets like China); that increases to roughly one billion if we widen it to households with broadband access. Without getting too cute on these figures, which are changing (getting much larger) over time, I think we can say the addressable market is currently at least 2x larger than Netflix’s sub base, especially when we include mobile-only plans. (He obviously has a certain bias, but here’s Roku CEO Anthony Wood: “In terms of the TAM, every broadband household that watches television is going to switch to streaming. So, it's one billion households.”)

Capitalizing on that opportunity will require that the service becomes highly desired by password sharers and people who have never used Netflix before. The path to get there is a familiar strategy for Netflix: an appropriate mix of local content, while leading on technology solutions like dubbing that make global / non-local content more enjoyable to watch for other viewers. If any company is positioned to capitalize on this opportunity, it is Netflix.

The past few years - specifically throughout 2022 - provided a reminder that the path to the long-term TAM will not be a straight line. That said, my view is unchanged from what I’ve said for the past few years: the global leader(s) in VOD will ultimately have a subscriber base that is measured in the hundreds of millions of subs. (Jason Kilar: “When people talk about a couple hundred million customers… I think that will be seen in hindsight as modest.”)

ARM’s (Average Revenues Per Membership)

While reaccelerated sub growth is a welcomed change, it’s only half of the equation; volumes must be considered in combination with pricing (ARM’s).

As it relates to the evolution of Netflix’s business in recent years, the following two charts provide some important context: despite significantly outsized sub growth in non-UCAN markets (mix shift headwind), Netflix has still managed to increase global (average) ARM’s by more than 30% since yearend 2016.

That outcome is attributable to continued UCAN ARM growth, as well as healthy ARM’s in markets like LATAM and APAC that are meaningfully higher than competitors. (At less than $4 per month, WBD’s International DTC ARPU is >50% lower than Netflix’s ARM for blended APAC / LATAM).

Last quarter, I wrote in detail about the UCAN growth algorithm. That discussion built upon the analysis from “Regional Economics and Global Scale”, which quantified Netflix’s regional P&L’s and explained why it’s useful to think about UCAN and non-UCAN as distinct businesses (if you have not read “Regional Economics”, I’d recommend doing so; it’s helpful for framing the evolution of the financials, particularly on gross margins / EBIT margins).