The Business Of

Movies | Netflix | Outlook

Morning All!

Happy Friday! We hope you’ve enjoyed the Netflix newsletters so far… it’s been slightly more upbeat than last week! Let’s have a quick recap of some of the fun, surprising things we’ve learnt about The Business Of Netflix this week.

• How Do They Make Money - a Netflix Standard subscription is cheapest in Pakistan ($3.06/month). And most expensive in Switzerland ($20.29/month).

• What Are Their Costs - it costs Netflix $1 every time we buy a TV set with a Netflix button on the remote control.

• What Do They Do With Their Profits - if you invested $1,000 in Netflix shares when the company IPOd in 2022. You’d have $274,000 now!

Today, for the final part, we’ll look at what the future looks like for Netflix. And I think the best way to do this is by going through the main EBIT drivers;

• Subscription revenues - can future growth be as strong as the past?

• Cost of content - can Netflix continue to reduce this cost as a % of revenue?

• New revenue streams - how big can these new streams of revenue become?

And shortly after this email gets sent out we’ll have a special Career Talk with someone who definitely knows a thing or two about Netflix…!

Career Talk - Asset Management

That’s right! It’s the next edition of our Career Talk newsletters. We’ve kept it a little under wraps this week. But it’s an absolute cracker - like honestly, probably our best one yet!

This week we’re exploring Asset Management with my friend Sam Thomas. After graduating from the University of Oxford in 2015, Sam became an Equity Associate @ Fidelity International. Eight years on, Sam is now Co-Portfolio Manager of the Fidelity American Fund and specifically covers the US Media space (including Netflix)!

I’ll be chatting to Sam about;

• how he got into his role at Fidelity,

• how an equity analyst divides their time between fundamentals vs valuation,

• what advice he’d give students in their stock pitches,

• what he thinks of Netflix’s recent strategy change, and,

• whether you should be spending that much time perfecting your DCFs!

It really isn’t one to miss! Especially for anyone who’s interested in equities! But before you click on that, let’s dive into the outlook for Netflix.

Joey Doesn’t Share Food Passwords

So, as we’ve seen this week - Netflix’s subscription model has been wildly successful for the company. Subscriber growth has been ~20% per year for the last decade. Average pricing has increased by ~5%. And overall revenues have grown by ~24% per year since 2014. The chart below (which we saw on Tuesday) shows us this incredible journey.

However, did anyone spot the revenue growth for 2022? 6%… that’s the lowest revenue growth Netflix has ever recorded! And the main reason for this was due to very sluggish subscriber growth. Netflix’s subscriber count at the end of 2022 was 231m, just 4% higher than the 222m recorded at the end of 2021.

And there are two main reasons for the poor subscriber growth:

1. Penetration levels are already very high - most people in the world have heard of Netflix. This means that if people wanted to subscribe to Netflix, they would’ve done it by now! It’s not like in 2012, where Netflix was yet to go to many countries. And there was plenty of white space.

2. Competition is fierce - whilst Netflix was the first player in streaming, the streaming industry has seen a load of new entrants. Disney+, Apple TV, HBO Max… I’ll stop there! But this means that subscribers now have more choice. And maybe they prefer the Disney shows. But can only afford one platform.

So what does this mean? Are the glory days over? Will Netflix revenue growth stay below 10% going forward? Well, not necessarily. And there’s a couple of things the company are doing to drive subscriptions revenues up…

One interesting strategy Netflix is using is clamping down on password sharing. As I’m sure we all know - it’s super easy to share passwords on Netflix. And so a lot of people watch Netflix without paying. Netflix estimate that up to 100 million people around the world use shared accounts! How will this strategy help Netflix? Well, by making people pay for sharing, it will raise the average revenue per subscriber. For instance in Spain, to share your account with someone outside your family will now cost an additional £5.32 a month. The risk to this strategy though is that cash-strapped consumers may just cancel their accounts altogether! Netflix must be wishing everyone was a little more like Joey… but with passwords, not food!

Another pricing lever the company could pull on is increasing subscription prices. As we saw on Tuesday, the company actually cut their subscription prices in 30 countries earlier this year. However, as the world moves out of the current recessionary environment, we could see Netflix continue to raise prices again. And really test consumers’ price elasticities of demand!

The third strategy Netflix could implement is to focus on less penetrated geographies. We’ve noted this week that subscriber growth has slowed for the company as a whole. And Netflix’s 2022 annual report shows us that US subscriber growth was actually negative at -1%. But are there regions where subscribers are still growing? Absolutely. In Asia, subscriber growth was a very healthy +17%. By focusing marketing efforts in these regions, Netflix could still drive overall subscriber numbers forward!

Tom Hanks Isn’t Cheap…

Okay, so we’ll come back to revenues in a moment. But let’s shift our attention to costs. And in particular content costs. Because the cost of acquiring and creating content is going up. Quite a lot.

And the intense competition brought about by the streaming wars has been the biggest driver. 4 of the Big 5 film studios have now set up their own streaming service. Paramount has Paramount+. Universal Studios has Peacock. Warner Bros has HBO Max. And of course, Walt Disney Studios has Disney+. Only Sony has stayed on the sidelines. But why does this rush to streaming lift content costs?

Well, let’s look at content creation. What are two of the main costs for Netflix or Disney+ or HBO Max to create a film? Talent and location. Finding the best talent and locations to shoot their films/shows. But as these streaming platforms rush to create new content, the demand for the best talent (like Mr Hanks above) and locations goes up. Putting upward pressure on the cost of that talent/location (A-Level economics refresher here)!

Okay, so what about acquiring content? Well, as we said, Sony is the one film studio that’s stayed on the sidelines. And the company has kind of taken the role of ‘content arms dealer’, licensing their content to the various streaming platforms. But with more streaming platforms all after Sony’s content (including Spiderman and Jumanji), we’re going to see a similar dynamic. Prices will go up. It will cost more for Netflix to license content from Sony and other content creators!

Alright, so costs are going up. But what’s the big drama… costs have been going up for a while! And yes that’s true. On Wednesday we saw that Netflix’s cost of revenues (basically content costs) have risen about 22% per year since 2012. From $3bn in 2012 to $19bn in 2022. But there is one difference now…

Because over the last decade, whilst cost of content has been going up. It’s been going up slower than revenue growth. Remember, what’s been absolutely crucial for Netflix has been that although yes, cost of revenues has increased massively over the last decade. These costs as a % of revenues has come down. Helping their margins grow over time. However, the tough question to ask is - can this continue?

We’ve seen above that there’s a good chance that subscription revenue growth will be slower than what we’ve seen previously. And with content costs rising, surely Netflix’s margins will come under pressure? Well, if you’re asking that question - I think you’re in good company…

Advertising To The Rescue?

… because I think Netflix’s management was thinking the same thing! For years, Reed Hastings (Netflix CEO) batted away questions of when Netflix were going to introduce ads to their platform. By saying the company weren’t interested. And that they wanted to focus on the customer experience. However, last year Netflix surprised everyone when they announced a massive U-turn on Ads.

What’s changed? Well, it’s what we’ve been talking about earlier. Content is becoming more expensive. Subscriber growth (and hence revenue growth) is slowing down. How can Netflix keep revenue growth ahead of growth in content costs? How about adding another revenue stream!

And that’s what Netflix have done. In November 2022, the company added a cheaper, ad-supported tier to their plans. For US consumers who may not want to fork over $15.49 for the Standard plan. Or $9.99 for the Basic plan. They can pay $6.99 for the Ad plan. And so far, the new tier seems to be gaining momentum. In Jan 2023, Netflix announced that 19% of new subscribers were signing up for the Ads tier.

Midnight cream anyone?

But hold on, if the Ads plan costs $6.99/month. And if a lot of subscribers don’t mind the occasional ad. Won’t Netflix lose money if Basic subscribers who pay $9.99/month move down to the Ad plan? This is a completely valid and good question to be asking. Because it makes sense. Won’t Netflix’s average revenue per subscriber be going down with the ads plan?

Well, apparently not! Netflix management have said that they believe the Ad tier will actually boost average revenue per subscriber. Because the revenues the company makes from advertising will far outweigh the $3/subscriber drop from Basic to Ads. Whether this is optimistic or not, we’ll find out. But one thing is for certain - advertising revenue will boost Netflix’s topline. Which then could allow the company to continue spending big on content - without harming their margins!

14th Apr 2023

Nigel Jacob CFA