Mario Tama
Netflix (NASDAQ:NFLX) deployed its ad-supported streaming tier in the middle of the fourth quarter, coming at an opportune time as the increasingly price sensitive consumer amid tightening financial conditions and a looming economic downturn escalate churn risks. Recall in our previous coverage that the streaming pioneer has launched the long-awaited service for $6.99 a month in 12 of its core regions spread across UCAN, EMEA, APAC and LATAM in early November. Though still in early stages of launch, take-rates on the new service have been favorable, though management had highlighted there’s “much more still to do” as expected. And paired with hot releases in the fourth quarter, ranging from scripted hits like “Emily In Paris Season 3” and “Wednesday” to non-scripted tell-alls like “Harry & Megan” and “Single’s Inferno Season 2,” Netflix certainly closed off a tough year with a bang (or “Tudum” in true Netflix formality). Despite missing earnings consensus estimates and guidance by a smidge, the company’s fourth quarter results had benefited from resilient net paid subscription adds of 7.7 million in the three months through December, which exceeded guidance of 4.5 million to finished the year with 231 million paid members.
2022 was a tough year, with a bumpy start but a brighter finish. We believe we have a clear path to reaccelerate our revenue growth continuing to improve all aspects of Netflix, launching paid sharing and building our ads offering.
Source: Netflix 4Q22 Shareholder Letter
Specifically, the company experienced slight declines in average revenue per membership (“ARM”) – not because of the anticipated pressure from the introduction of the new lower-priced “Basic with Ads” service and continued expansion of subscription growth in less profitable regions like APAC and LATAM, but instead due to FX, with growth being at 5% y/y stripping the macro challenge. Sales remained resilient despite the anticipated softening and persistent FX challenges – the company’s revenue grew 2% y/y in the fourth quarter, or 10% exclusive of FX headwinds, thanks to a “4% increase in average paid memberships.” Meanwhile, full-year 2022 operating margins finished at 18% despite the harsh FX headwinds, as well as “$150 million in restructuring charges in Q2’22,” excluding the cyclical and one-off costs, full year 2022 operating margins would have finished at the higher end of management’s guided 19% to 20% target.
Looking ahead, changing consumer trends in response to mounting macro uncertainties in the near term will remain a key influencer over Netflix’s performance – both in terms of subscriptions and advertising take rates. The following analysis will provide an overview of Netflix’s performance in the fourth quarter, as well as the implications, with additional consideration of broader macro- and industry-specific factors, on Netflix stock’s near-term prospects. We believe the demand environment for streaming ads will remain strong as it continues to expand toward dominant consumer reach over the longer term, though its economics will likely weigh on Netflix’s fundamental performance in the near term given early stages of scale. Paired with tightening financial conditions in the near term and more structural industry-specific risks – especially pertaining to growing competition – Netflix stock likely remains exposed to escalated vulnerability to fragile market sentiment over the coming months.
An Overview of Netflix’s 4Q22 Results
Netflix was one of the hardest hit names – both in terms of its fundamental and stock performance – during the 2022 market rout. Its lofty valuation premium, which ballooned during the pandemic-era run-up, buckled on souring investors’ sentiment, with the stock losing more than 70% of its market value in the first half of 2022 due to substantial churn, before paring losses to the 50% range following meaningful improvements in the second half. Netflix’s overall performance proved relatively resilient in the second half of the year, as post-pandemic churn gradually normalized. However, recent results continue to underscore maturing share in its most profitable regions like UCAN and EMEA. In UCAN, Netflix added less than 1 million new paid subscriptions in the fourth quarter. Although arresting declines experienced earlier in 2022, it appears Netflix’s strong slate of new premium content releases in the final quarter of the year did little to ensure outperformance in net subscription adds in its most profitable region from the prior year. But the segment’s revenue grew, nonetheless, thanks to resilient ARM growth as management had noted. EMEA experienced similar trends as UCAN when it came to net subscription adds, with a year-over-year decline despite sequential acceleration that arrested a first half paid net losses. But the region’s sales declined by close to 7%year-over-year given ARM decline of as much as 10% due to extreme FX challenges (ARM +5% y/y on a constant currency basis).
Looking ahead, Netflix has guided free cash flow generation of $3 billion for full year 2023, almost twofold from the $1.6 billion generated in full year 2022. The results will be driven primarily by “sustaining double-digit revenue growth (and expanding) operating margin” through ramping up new features including Basic with Ads and launch of paid sharing to new regions starting the current quarter.
While the first half of 2023 is expected to present a tough PY comp environment for many of Netflix’s ad tech peers, given strength in ad sales in the first half of 2022 and inherent sensitivity to looming macro weakness within the industry over coming months the streaming giant will likely be spared from said headwinds as it continues to scale its new Basic with Ads offering and behind-the-scenes ad sales. Specifically, the first half of 2023 is expected to include persistent FX headwinds for Netflix and anticipation for reasonable churn due to the impact of paid sharing, with the second half of the year likely to improve and drive the company’s aggressive full year free cash flow generation operations as sharing households “begin to active their own standalone accounts and extra member accounts are added,” and Basic with Ads continue to attract new sign-ups.
Benefitting from CTV Ad Resilience
As discussed in our previous coverage, Netflix introduced its long-awaited ad-supported tier, Basic with Ads, in early November across 12 countries, including the U.S., Canada, France, UK, Germany, Italy, Spain, Mexico, Brazil, Australia, Japan and South Korea. Priced at $6.99 per month (or as low as $5.99 in regions like Canada), the Basic with Ads tier makes a budget-friendly option, targeting individual users with a $3 discount to its ad-free equivalent under the “Basic” tier. Similar to peer streaming platforms that already offer ad-supported options, Netflix’s Basic with Ads will show about “four to five minutes of commercials per hour (at) 15 or 30 seconds in length,” and consist of a slightly smaller content library streamed at a lower video quality of up to 720p/HD with no option to pre-download titles.
From the perspective of ad sales, Netflix will leverage its first-party viewer data to ensure “advertisers reach the right audience (and) ads are relevant for consumers.” And the deployment comes at an opportune time, as consumer preference shifts from SVOD (streaming video on demand) to AVOD (advertising-based video on demand) thanks to increasing availability and more attractive pricing on the latter option.
American households are currently subscribed to 3.7 streaming services on average, up from 3.5 in 2021, with younger and more affluent consumers being core drivers of adoption (consumers under the age of 44 are likely subscribed to more than four streaming services). More than a fifth of streaming users “prefer ads to subscriptions on an absolute basis,” with more than half of the cohort citing pricing sensitivity for their choice. Age plays a larger role in determining ad tolerance, with users above the age of 44 “more willing to choose ads.”
However, household income appears to play a lesser role in determining ad tolerance, with latest industry surveys showing “no significant correlation around pricing or preference for subscription over advertisements.” In fact, American households with annual income over $100,000 are only willing to pay $6.40 per month on average for streaming without ads, slightly less than the $7.10 per month that those with annual income under the $100,000 threshold are willing to pay. This potentially implies that AVOD will likely fare better than other digital ad distribution formats within the near term, despite the industry’s inherent sensitivity to looming macroeconomic headwinds (discussed further below). The nationwide average willingness to pay per month “in order not to watch advertisements,” extrapolated from recent industry surveys, is approximately $6.80 per month. And specific to Netflix, the figure jumps to $7, equivalent to what the service currently charges for the ad-supported tier.
Results gathered from recent industry surveys on streaming content consumers indicate that there’s a robust demand environment for AVOD – even if current market prices for the budget-tier remain slightly higher than what the average consumer is willing to pay – making the ad distribution format an attractive one for advertisers to maximize consumer reach, engagement, and ultimately, conversion. And given Netflix’s global leadership in streaming market share with 231 million paid subscribers at the end of 2022, its newly-introduced AVOD service is likely to ramp up toward becoming one of the highest reach digital ad distribution formats, underscoring potential for sustained advertising sales, in addition to subscriptions, over the longer-term as well.
Despite the advertising industry’s inherent sensitivity to macroeconomic challenges, connected TV (“CTV”) ads will continue to benefit from accelerated demand within both the near and longer term as a result of the format’s growing reach. Streaming ad demand is expected to expand 18% y/y in the current year, beating the “tepid uptick of 4.6% in the global ad market,” and account for $23 billion in related sales in 2023. Much of the industry’s momentum will be reinforced by the injection of new ad inventory as a result of continued expansion of “ad-supported tiers launched for Disney+ (DIS) and Netflix,” among other streaming platforms. And the secular shift from linear TV to CTV is expected to drive faster AVOD ad sales growth over the longer term, making strong tailwinds for Netflix given its dominant market share. Specifically, CTV market share erosion against linear TV is expected to accelerate within the foreseeable future, expanding from 1.7% share of combined TV ad spend in 2015, to 21.1% by 2027. This would be categorized by a CTV ads sales CAGR of 13.5% between 2021 to 2027, outpacing the global ad spend CAGR of 5.7% over the same period. This is further corroborated by streaming’s recent domination against linear TV pertaining to share of viewership in the U.S. Streaming surpassed linear TV viewership for the first time over the summer with 35% share of total TV screen time, and the dominance has only gradually accelerated to more than 38% by November, underscoring the structural shift in consumer preference.
Hurdles in Ramping Up AVOD Ad Sales
However, as discussed in our previous coverage, there are still many hurdles in turning the nascent streaming ad distribution format into the primary preference for advertisers like search ads.
One of the key hurdles is measurability of ad performance. Although Netflix is clearly not the first to engage in streaming ads, it remains one of the few platforms that favor full season releases over weekly releases, which makes it difficult for advertisers looking to optimize ad placements:
Specifically, advertisers have been known to “secure TV commercials months in advance, but they can also buy spots mid-season if a show suddenly becomes popular.” On this basis, if Netflix sticks by its historical practice of rolling out all episodes of a new show at once, it could potentially complicate the process for advertisers.
Source: “Netflix is Getting Desperate”
Netflix could insert ads into shows that suddenly become part of the cultural zeitgeist, but that may be too late for advertisers. The bulk of the viewing would likely have occurred before an advertiser decided to build a campaign around the program. It can be easier to do this when a program runs over a conventional multi-month schedule.
Source: Bloomberg News
And Netflix’s higher ad costs charged to advertisers relative to its AVOD peers also heightens forward execution risks for the new endeavor. For instance, rival HBO Max, currently operated by Warner Bros. Discovery (WBD), recently disclosed that its advertising CPMs, or cost per mille – which measures the price advertisers pay for “every 1,000 impressions an ad receives” – are already on par with its linear businesses. Meanwhile, Netflix is charging almost twofold the average market rate at “more than $60 per thousand viewers.” Considering AVOD users – especially those viewing on TVs – are typically less engaged with ads compared to consumers on browser formats like search and retail media, the higher price point charged to advertisers dials up expectations for Netflix to deliver – especially considering the near-term macroeconomic challenges that have turned advertisers to the sidelines, stifling TAM expansion across the broader digital ads industry. As such, ad sales and Basic with Ads subscriptions at Netflix through 2023 will remain critical watch items, as investors look for consistent positive progress on ramping the new revenue streams towards scale to sustain upside potential for the stock.
Another hurdle is advertisers’ increasing preference for “open internet” digital ad formats over “walled gardens.” Walled gardens describe ad formats that rely on a “closed data ecosystem that generally allows organizations to track the activity of logged-in users across devices” – similar to Netflix’s reliance on first-party data collected on its subscribers’ preferences for the delivery of targeted ads. It’s called a walled garden because measurability and performance comparability remains a roadblock for advertisers on said ad formats. Specifically, the lack of measurability on the effectiveness of streaming ads as discussed in the earlier section due to the nascent nature of the business, and inconsistencies across their delivery formats (e.g. Netflix’s whole-season release strategy vs. peers’ weekly-release strategy) continue to make it difficult for advertisers to “conduct apples-to-apples comparisons of campaign performance across AVOD platforms,” especially given increased inventory of streaming ad slots with pent up deployment of ad-supported platforms:
As CTV viewing continues to gain traction, advertisers are recognizing the limitations of purchasing CTV inventory based only on audience attributes. Oversaturation of ads due to lack of frequency controls, and the inability for advertisers to align their ads with chosen content post continued challenges… As AVOD platforms continue to sell their inventory based on audience profiles, media buyers risk paying premium prices for audiences that are not engaged or paying attention.
Source: T-Vision Insights
There’s also increasing consumer preference for open internet ads (e.g. display ads; pop-up ads across browser and in-app formats), which could be a hurdle for Netflix’s new ad delivery strategy. More than 80% of consumers “turn to the open web first for information on a business (and) products to buy” and find said ads more relevant than those delivered via walled gardens like social media and video streaming platforms. And advertisers are pressed to “seek greater transparency into the control over their ad strategies,” escalating urgency for digital ad platforms like Netflix to improve measurability and comparability of its format’s performance by shifting away from over-reliance on a walled garden strategy and cater to the open internet set-up instead.
The aforementioned hurdles continue to underscore how execution risks remain elevated for Netflix as it continues to ramp up its new ad-driven revenue streams. While there’s potential for the streaming pioneer to sustain the ad-supported tier’s subscription and ad sales growth, and carve out a new high margin revenue stream to support its industry-leading positive free cash flows over the longer term, the company remains in early stages of proving whether the nascent growth initiative will work, and mitigate its exposure and vulnerability to competitive disruption. Increasing saturation within the AVOD landscape also is expanding related ad inventory. Met with potential near-term macro-driven demand risks, streaming ad formats could potentially face a competitive pricing environment, which could be a headwind for Netflix given its higher CPM relative to peers’. Competitive AVOD CPMs could also weigh on Netflix’s margin expansion trajectory for Basic with Ads and delay its longer-term aspirations of achieving a higher ARPU for the budget-tier over the standard and premium ad-free tiers.
But within the near term, increased momentum in streaming adoption and ensuing ad reach will continue to erode linear TV’s share of combined TV ads, buoying resilient growth in the format despite risks of TAM contraction ahead of the looming economic downturn. This could be favorable for Netflix as it continues to ramp up the new ad-driven revenue streams and benefit from a more resilient corner of the industry ahead of mounting macroeconomic uncertainties facing its recession-prone core subscription business. AVOD’s ability to mitigate near-term digital advertising demand risks is further corroborated by observations by industry monikers like Magnite (MGNI), a global “independent sell-side ad platform”:
In CTV, we also have growing momentum. And even in the case of recession, we think that we have some – we would expect some countercyclical support that could be beneficial, in particular potential acceleration in cord cutting and growth of AVOD as households perhaps move down from the higher tiers on their streaming subscriptions. And so stepping back from that, we’re confident that even in a more recessionary environment, we expect to grow.
The Bottom Line
Netflix’s core competitive advantage remains that it’s currently the only profitable streaming platform, with dominant market share across core markets counting UCAN, EMEA, APAC and LATAM. But growing competition is diluting its market share, nonetheless, as observed via deceleration its most profitable regions, UCAN and EMEA. Meanwhile, a costly content arms race is also ramping up at a time when the company’s free cash flow generation abilities are normalizing, as its first-mover advantage critical in supporting margin expansion over past years fades. A key to reinforcing subscription and ad sales growth is via the consistent release of “premium content,” which is strongly correlated to the “increase in total time spent” by users on a specific streaming platform, and all-the-while, a capital-intensive undertaking for the operator.
The rapid decline in Netflix’s market value over the past year reflects investors’ expectations for normalized growth and a more tempered cost-return spread going forward given inevitable exposure to competitive headwinds. Despite market’s positive response to the company’s revenue beat and subscription outperformance in the fourth quarter, with stock price gains of more than 9% in post-market trading Jan. 19 after its earnings release, near-term tightening of financial conditions (e.g. surging interest rates; persistent inflation; looming recession), paired with execution risks on its new revenue streams – primarily pertaining to Basic with Ads subscriptions and related ad sales, alongside other undertakings like the broader rollout of paid sharing through 2023 – will likely continue to weigh on the shares’ performance.
Be the first to comment