How high can the soaring Netflix "fly"?

$Netflix(NFLX.US) Netflix released its third-quarter 2024 financial report after the market closed on October 18th, Eastern Time: The performance is still good, with all key indicators meeting or slightly exceeding market expectations. As mentioned by Dolphin in the previous quarter, the market was overly concerned about Netflix's third-quarter revenue guidance missing expectations. In the short term, in a relatively stable competitive environment and with Netflix's usual peak season in the second half of the year, it can clearly remain relatively positive.

In addition to slightly exceeding expectations for the fourth quarter guidance, Netflix also provided guidance for 2025. In terms of revenue and profit, it basically falls within the market's expected range, but the implied profit margin increase is slightly slower than market expectations, possibly due to the impact on short-term profit levels when the lower-priced advertising packages are further promoted on a large scale next year.

Key points of the financial report:

1. User Growth: Met expectations in Q3, expected to rise in Q4 due to peak season and hot content

Netflix added 5.07 million net users in the third quarter, in line with Bloomberg's consensus expectations and basically meeting the expectations of leading institutions.

For user growth in the fourth quarter, Netflix expects it to be higher than the third quarter due to seasonal changes. However, with the release of "Squid Game" Season 2 and popular sports programs like "The Jake Paul/Mike Tyson fight," user growth in Q4 is expected to remain strong.

2. Europe and Asia remain the main drivers of user growth

With the slowdown in North America due to the impact of the crackdown on password sharing and the continued effects of the price increase at the end of last year, Europe and Asia have become the main sources of user growth, while Latin America saw a decline on a month-on-month basis.

According to third-party data:

The UK, France, Germany, as well as Japan and India, were the countries with the highest growth this quarter. In addition to some common customer acquisition strategies, Netflix mainly relies on increasing investments in local content production to penetrate the market.

In Latin America, countries like Brazil saw a decline in downloads on a year-on-year and month-on-month basis. The company attributes this to price increases and limited local content supply, but Dolphin believes it may also be due to the fact that Latin America was the first region to implement the password sharing strategy, so the benefits of these measures have gradually diminished.

3. Increase in the proportion of advertising users

In the third quarter, ARPU in the US and Canada continued to decline on a month-on-month basis, while other regions saw growth. Despite price increases in the US and Canada in the past six months, there is no "apparent" price increase effect in terms of average per capita payment, reflecting the increase in the proportion of users in the advertising tier. Currently, the advertising inventory has not been fully utilized, and users in the lower-priced advertising tier will naturally drag down the overall ARPU.

The company disclosed that advertising users grew by 35% in the third quarter, compared to 34% in the previous quarter. In May, the company disclosed that it already had 40 million advertising package users, and roughly calculated, it has now exceeded 70 million, accounting for over 25% of total users

4. 2025 Revenue and Profit Guidance in Line with Expectations

In the third quarter, the company's operating profit was 2.9 billion, a year-on-year increase of 52%, further accelerating from the previous quarter on a high base. This was mainly due to steady double-digit revenue growth of 15%, while continuing to control costs and expenses.

However, the improvement in gross profit margin this quarter may also have some incidental factors. The amortization of content costs in the third quarter decreased slightly compared to the previous quarter, which may be related to a slight lack of major content compared to the same period last year. Therefore, when several hit shows are released in the fourth quarter, these costs will also increase. In terms of the overall trend, after Netflix's content investment went through a strike wave, the investment cycle is still in a steady recovery state.

The increase in investment also affects the current free cash flow. Netflix's content investment budget for 2024 is 17 billion, with less than 12.5 billion spent in the first three quarters, meaning that 4.5 billion will need to be spent in the fourth quarter, accelerating once again. However, due to the increase in revenue and profit margins, the company has raised its free cash flow guidance from 5-6 billion to 6-6.5 billion.

With positive expectations for combating account sharing, advertising revenue, and price increase effects, the company has raised its operating profit margin for 2024 to 27%, while expecting 28% for 2025. This cross-year increase is expected to slow down to a certain extent. Dolphin Jun predicts that after further increasing advertising users, the short-term advertising inventory may not be sufficient, and the overall value per user is still lower than the standard ad-free package, which in turn affects the increase in profit margin.

5. Borrowing Money to Buy Back Shares

As we all know, Netflix has historically issued bonds for financing multiple times because in the early days when profits were thin, the massive content investment required upfront funding to proceed. Due to being in a new investment cycle, Netflix does not have a lot of idle cash on hand.

In the previous quarter's financial report review, Dolphin Jun mentioned the 600 million gap between investment and working capital. As expected, in the third quarter, Netflix initiated a new round of financing, issuing the highest-rated blue-chip bonds for the first time, raising $1.8 billion, mainly to repay short-term bonds due in 12 months.

Although they had to raise funds due to short-term funding gaps, Netflix did not slow down its share buybacks. In the third quarter, they spent $1.7 billion to repurchase 2.6 million shares, with an authorized repurchase amount of $3.1 billion still available.

6. Performance Indicators Overview

Dolphin Research Viewpoint

Starting from 2023 when peers began to focus on profits rather than growth, it means that the streaming media environment where Netflix is located has begun to change, at least the competition is no longer too intense. The Hollywood strike wave in the second half of the year further exacerbated this trend, but Netflix, with its content library advantage, has relatively benefited, allowing its anti-account sharing, advertising packages, and successive price increase reverse actions to be smoothly implemented, while peers seem to have not gained much benefit.Returning to the fundamental point, users still pay for good content, and cheapness is not the most core influencing factor. Therefore, this is also the reason why Dolphin Jun proposed at the end of last year that there is no need to worry too much about the fundamentals of Netflix in the short-term one-year dividend period.

However, as we enter 2025, when the dividend period of cracking down on account sharing gradually comes to an end, the early impact factors in the industry weaken, and the competition among peers intensifies further (in Q3, due to the weak content supply of Netflix, there have been initial signs of competition in market share), how can Netflix maintain its growth? Especially when compared with the high expectations implied by the current valuation (the current market value corresponds to a 25-year Forward PE of 30x, with next year's revenue growth guidance at 12% and expected operating profit growth at 16%), more actions need to be taken to withstand the pressure of high expectations.

Sports and gaming are currently the major investment directions for Netflix. The latter is a natural operation after the maturity of Netflix's IP, and it has not been monetized separately yet, mainly filling in membership benefits. The former, sports content, is more like a business model transformation combined with advertising packages.

However, whether the effects can meet expectations may still need to be observed. Especially in the short-term advertising profit model, there may still be some pressure before advertising tracking, positioning technology, and partnership ecosystem are improved. Currently, Netflix mainly cooperates with advertising platforms, but there are plans to do its own advertising placements later. Therefore, whether the high market expectations here can hold up is also a question mark.

The market's growth driver for Netflix also includes "price increases," which are based on the assumption that the overall user base growth is slowing down. However, Dolphin Jun believes that in the absence of advertising packages, with prices already raised to the top among streaming services, how much further room for price increases there is, needs to be considered in conjunction with the pipeline of competitors. Dolphin Jun currently leans towards caution on this point.

Details are as follows:

I. User Growth: Met expectations in Q3, expected to rise seasonally in Q4 with hit shows

In the third quarter, net additions of subscribing users reached 5.07 million, exceeding Bloomberg's consensus expectation of 4.5 million. Major institutions were also around 5 million, so Netflix's performance can be said to meet expectations. User growth still stems from cracking down on password sharing and the introduction of advertising packages.

Looking at different regions, growth in North America continues to weaken month-on-month, possibly due to the diminishing benefits of advertising package promotions and price increases. In other regions, Asia and Europe remain the main drivers of growth, with significant increases in Japan, India, the UK, and France.

The company plans to continue expanding advertising packages to more regions. As of Q3, the scale of advertising users increased by 35% compared to the previous quarter (sequential growth rates in 3Q23, 4Q23, 1Q24 were 70%, 70%, 67%, 35%), implying that the scale should have exceeded 70 million.

For the fourth quarter of 2024, the company is expected to have a net increase in users higher than the third quarter due to seasonal effects. The current market consensus is 7.09 million. Considering the boost from the second season of "Squid Game" and two popular sports programs, Dolphin believes that exceeding expectations is not difficult.

Although the third quarter is also a peak season, the seasonal changes compared to the second quarter this time, apart from the diminishing dividend of shared accounts, are mainly due to the issue of content supply gap. At least compared to the same period last year, the viewership of the top 10 series in the third quarter this year is not as good as last year.

In the medium to long term, the main logic is still the replacement of cable TV by streaming media, and Netflix maintaining its competitive advantage and industry-leading position in streaming media. According to Nielsen data, although the third quarter had the Olympics and the U.S. presidential debates (usually watched on cable TV by users), the streaming media viewership share still increased by 1 percentage point to 41%, reaching a new high.

II. North America continues to slow down, while Europe and Asia remain the main drivers of user growth

In the third quarter, Netflix achieved a total revenue of $9.83 billion, a 15% year-on-year increase, slightly weaker than the previous quarter. The DVD business has returned to zero after the company announced its complete closure at the end of the third quarter of 2023.

The growth of the streaming media business is mainly driven by user scale. Although there have been price increases in some European and American regions in the past six months, in terms of average revenue per user (ARPU), there is no "superficial" price increase effect. Except for Latin America, where ARPU can still grow due to a relatively large price increase, ARPU in other regions has declined compared to the previous quarter.

This actually reflects the increase in the proportion of ad-supported users. Currently, with ad inventory not yet fully utilized, ad-supported users with lower membership fees will naturally drag down the overall ARPU.

The company disclosed that ad-supported users increased by 35% quarter-on-quarter in the third quarter, compared to 34% in the previous quarter. The company disclosed in May that there were already 40 million ad-supported users, and roughly calculated, it has now exceeded 70 million, accounting for over 25% of the total users.

Netflix's performance in the last quarter may not be supported by advertising revenue until 2025, but the contribution ratio will increase. The market estimates that advertising revenue currently accounts for about 5%. However, the monetization ability of advertising is highly related to traffic, so the company's current strategy of expanding user base is correct. For example, following the routes of the UK, France, and North America, accelerating the phasing out of basic plans, and promoting advertising plans in more regions.

Although it may temporarily lower the average revenue per user (ARPU), especially considering Amazon Prime's data showing a certain decline in user engagement after adding advertisements, this will undoubtedly have some impact on the performance in 2025, especially in terms of profit growth pace.

However, if advertising technology can be improved and the adaptation period can be overcome, in the long run, the ARPU of advertising users will still be relatively higher than that of basic users. This indirectly improves the company's monetization efficiency, which means profit margins will increase.

However, Dolphin believes that for Netflix, which lacks advertising experience, it still needs to take it step by step. Netflix needs to prove that its advertising conversion rate requires more investment in basic technology or cooperation with external advertising companies. After all, it is not only competing with YouTube but also facing competition from Google, Amazon, and others.

III. Competitive Environment: Focus on the competition threat from YouTube and Amazon

In previous discussions, Dolphin judged that Netflix will be in a relatively comfortable position within this year. Although in the third quarter, due to the relatively weak content supply, you can see YouTube and other competitors catching up in terms of viewership share.

According to Nielsen's data, Netflix's viewership share dropped to 7.9% in the third quarter, while YouTube and Amazon Prime Video continue to rise. Disney's share increased due to bundling Hulu with Disney+, but Hulu's share decreased, maintaining stability overall.

However, apart from YouTube constantly grabbing market share, whether the competitive momentum of other competitors can continue to be maintained remains to be seen. Dolphin suggests continuing to observe the fourth quarter. With the increase in content supply in the fourth quarter, if viewership share can recover, it indicates that the short-term competitive environment remains relatively stable.

IV. Financing to Fill the Cash Flow Gap, Repurchase Continues

At the beginning of the year, Netflix set a target of $17 billion in content investment for this year. As of the third quarter, $12.4 billion has been spent, with a quarter-on-quarter decrease in investment amount but an accelerated year-on-year growth. Currently, 27% of the annual quota remains, meaning that investment in the fourth quarter will continue to accelerate

In the third quarter, free cash flow rose to 2.19 billion, and due to the improvement in operating profit margin, the full-year cash flow target for 2024 was raised from 5-6 billion to 6-6.5 billion. However, in the previous quarter's review, Dolphin mentioned Netflix's funding gap issue, which was resolved in the third quarter through bond issuance. The 1.8 billion raised through bond financing will be used to repay bonds due within 12 months.

Despite the short-term funding gap issue that necessitated financing, Netflix did not slow down its buyback. In the third quarter, it spent 1.7 billion USD to repurchase 2.6 million shares, with an authorized buyback amount of 3.1 billion remaining.

V. Pace of profit margin improvement next year may slow down

In the third quarter, Netflix achieved an operating profit of 2.9 billion, a significant increase of 52% year-on-year, with a profit margin increasing to 29.6% on a quarterly basis, raising the full-year operating profit margin target from 26% to 27%, a 7 percentage point increase year-on-year.

Breaking it down, the increase in profit margin in the third quarter may be due to occasional increase in gross margin caused by lower amortization costs due to weaker content in the current period. In terms of operating expenses, while administrative expenses significantly decreased year-on-year, marketing expenses and research and development expenses accelerated.

The company's operating profit margin guidance for 2025 is 28%, a 1 percentage point increase compared to 2024, indicating a significant slowdown in the pace of improvement. While 28% aligns with market expectations, the market expected a 2 percentage point increase to 28%.

Dolphin believes that a major factor here is the increase in the proportion of advertising revenue next year, which, due to the temporarily lower unit price, will drag down profitability. In addition, new content investments in sports, games, movies, etc., will also require more marketing promotionAnd in order to build its own advertising system and enhance advertising tracking, positioning, and other technologies, research and development expenses are also difficult to optimize. Therefore, if the competition among peers intensifies next year, it cannot be ruled out that it will have a greater impact on Netflix's short-term profitability.

Although Netflix has an absolute monopoly advantage in the industry, whether there will definitely be pressure still needs to be observed as things develop. However, for the current implied performance growth expectations, the above factors will undoubtedly greatly reduce the further upside potential of Netflix's valuation.

Dolphin Research on "Netflix" Historical Articles

Earnings Season

July 19, 2024 Earnings Call " Netflix: Advertising Will Become the Main Growth Driver in 2026 (2Q24 Earnings Call)"

July 19, 2024 Earnings Review " Answer Sheet is Good But Expectations are Higher, Is Netflix a Prequel to the Seven Sisters?"

April 19, 2024 Earnings Call " Netflix: Focus on User Interaction Metrics Rather Than Just User Numbers (1Q24 Earnings Call Summary)"

April 19, 2024 Earnings Review " Netflix: Strong Now, But About to "Collapse"?"

January 24, 2024 Earnings Call " Netflix: Expanding Content Investment, Using Good Content to Drive Price Increases (Netflix 4Q23 Earnings Call Summary)"

January 24, 2024 Earnings Review " Netflix: Content Dominator with a Strong Foundation, True Gold Does Not Fear Fire"

October 19, 2023 Earnings Call " Netflix: Hoping to Return to Previous Investment Levels to Drive Growth (3Q23 Performance Call Summary)"

October 19, 2023 Earnings Review " Growth Questioned? Netflix Raises Prices in Retaliation"

July 20, 2023 Conference Call "The Effect of Cracking Down on Account Sharing Will Further Emerge (Netflix 3Q23 Performance Conference Call Summary)"

July 20, 2023 Financial Report Review "Netflix: Squeezed User Growth, Market Unconvinced?"