The answer is not bad, but the expectations are higher. Will Netflix be a preview of the Seven Sisters?

$Netflix(NFLX.US) Netflix released its second-quarter 2024 financial report after the market closed on July 18th Eastern Time: It met the market's high expectations and delivered a satisfactory performance. However, as the buyers with pricing power were already optimistic, the market's reaction was subdued after the earnings release.

However, Dolphin believes that the second-quarter performance was actually good. The revenue guidance being lower than expected is not a major negative factor. The key indicator—net addition of paid users—gained 8.05 million users during the off-season, showing a significant improvement compared to previous years.

Although the user guidance for the third quarter is not surprising, due to the short-term stable competitive environment and Netflix's usual peak season in the second half of the year, Dolphin is slightly more positive.

Key points of the financial report:

1. User Growth: Strong Q2, potential weakening trend in Q3

Netflix added 8.05 million net users in the second quarter, slightly exceeding institutional expectations and basically meeting buyer expectations. Compared to seasonal changes in previous years, it was still considered "better than expected."

Market expectations have been gradually increasing along with the performance disclosed by third-party data. At the end of April when the first-quarter report was released, the market's expectation for user growth in the second quarter was only 4.5 million. For the Q3 guidance, management expects it to be lower than the high base of Q3 2023 (8.76 million), which is largely within the market's expectations.

However, when compared to Q2 (8.05 million), it may appear slightly weaker, as the third and fourth quarters are traditionally considered Netflix's peak seasons, with a significant increase in user numbers compared to the second quarter in previous years.

2. What drives user growth? Content internationalization

Benefiting from the slowdown in growth in the North American region due to the impact of the crackdown on account sharing, Asia has become the primary source of user growth in the second quarter.

According to third-party data, countries like Japan, Indonesia, and India saw the highest growth. These regions happen to have relatively low Netflix penetration rates, so efforts were made last year to promote growth in these areas. In addition to some common customer acquisition strategies, there was also increased investment in local content production. For example, the Indian show "The Great Indian Kapil Show" premiered at the end of March and became one of the most-watched content in the second quarter.

3. Further increase in the proportion of ad-supported users

Although some regions in Europe and America have experienced price increases in the past six months, there is no "apparent" effect of price increases in terms of average revenue per user (ARPU). Except for Latin America, where ARPU can still grow due to significant price increases, ARPU in other regions has decreased compared to the previous period.

This reflects the increase in the proportion of ad-supported users. Currently, the ad inventory is not yet full, and users in the lower membership fee ad-supported tier naturally drag down the overall ARPU The company disclosed that currently, in the market regions where the advertising layer is implemented, the proportion of users choosing the advertising layer has reached 45% (up from 40% in the previous quarter), with a quarterly growth rate of 34% in the number of advertising users. The market is expected to have around 40 million advertising users by the end of 2024.

4. Further Increase in Revenue and Profit Guidance

In the second quarter, the company's operating profit was 2.6 billion, a year-on-year increase of 42%. This was mainly due to steady double-digit revenue growth of 17% while continuing to control expenses. However, the gross profit margin slightly decreased, which was related to increased investment in film and television, and accelerated growth in content amortization.

Due to positive expectations regarding combating account sharing, advertising revenue, and price increase effects, the company has once again raised its growth and profit margin guidance from the previous quarter. Revenue has been increased from 14% to 15%, and operating profit from 25% to 26%. However, as market expectations are already high, there is no substantial positive impact, mainly aimed at boosting market confidence in its growth.

Increased investments also have an impact on the current free cash flow. Therefore, despite the increase in revenue and profit, the company has not adjusted its guidance for free cash flow accordingly.

5. Repurchasing Even with Limited Funds

As we all know, Netflix has historically issued bonds multiple times for financing because in the early stages when profits were thin, substantial content investments needed to be funded first to progress. Due to being in a new investment cycle, Netflix does not have a lot of idle cash on hand.

As of the end of Q2, the company had $6.7 billion in cash and short-term investments, with an expected $3 billion free cash flow inflow in the second half of the year. However, $8.5 billion needs to be invested in content production, and $1.8 billion in debt will mature within a year, creating a potential funding gap of $600 million.

Nevertheless, despite this, Netflix continued its repurchase actions at a high stock price in Q2—spending $1.6 billion to repurchase 2.6 million shares. Therefore, if the company wants to maintain this repurchase pace, it is not ruled out that Netflix may need to issue new bonds. However, due to the currently high cost of bond financing, it is possible that the repurchase pace may not be sustainable.

6. Performance Indicators Overview

Dolphin Research Viewpoint

Similar to the first quarter, the second quarter report also suffers from high buyer expectations, resulting in a "mediocre" performance for the current period and disappointing guidance for the next quarter. However, in the past two weeks, Netflix's valuation has retraced along with Big Tech, so there hasn't been a collapse as seen in Q1.

Dolphin believes that looking at the performance in the second quarter, it is still very good, especially the key indicator—subscriber numbers, which have reached investors' optimistic expectations during the relatively content-light season.

As for the missed guidance, Dolphin believes it can remain calm for now, as the core issue lies in the fact that the competitive environment has not undergone significant changes: at least within this year, traditional film and television giants have not yet experienced strikes or content shortages due to reducing investments to cut losses. There will be a relatively relaxed competitive environment within the industry, which is a bonus period for Netflix with a large inventory of high-quality content. **

However, in terms of valuation, we believe that it is still in a neutral position without being overvalued, but the potential is somewhat lackluster. Nevertheless, market expectations are more optimistic than Dolphin Jun, with a projected profit CAGR growth rate of over 30% from 2024 to 2027, depending on confidence in seizing market share through advertising and Netflix's further expansion into specific content, such as sports.

Dolphin is somewhat positive about Netflix's user growth this year, but maintains a cautious outlook on growth trends after this year, mainly due to traditional content and the impact of Big Tech's streaming platforms, which will gradually overcome the effects of reduced losses adjustment and Hollywood strikes on film and television content investment, passing through a content drought phase.

Netflix's growth story in the past two years has been primarily driven by cutting-edge trends. However, whether it is combating account sharing or introducing advertising layers, the ability to achieve smooth user penetration and steadily increasing profits with relatively low content investment ultimately stems from a competition landscape that has significantly slowed down compared to 2022.

Therefore, the turning point of trend reversal is also when the competitive environment tightens again. In this regard, Dolphin Jun tends to be relatively cautious and leans towards waiting for a good price.

The detailed content is as follows:

I. User Growth: Good in Q2, Potential Weakening in Q3

In the second quarter, the net addition of subscription users was 8.05 million, exceeding Bloomberg's consensus expectation of 4.9 million. However, the latest expectations from top institutions have been raised to 6-7 million, while investors expect even higher numbers, hoping for an increase of over 8 million. Therefore, the "better-than-expected" value is not as high. The user increase still stems from combating account password sharing and the introduction of advertising packages.

Looking at different regions, growth in North America weakened compared to the previous quarter, possibly due to the diminishing benefits of advertising package promotions and price increases; in other regions, Asia continues to be the main driver of growth, with significant increases in Japan, India, and Indonesia.

The company plans to continue expanding advertising packages to more regions. As of Q2, in regions where advertising packages have been introduced, advertising users account for 45%, with a user base growing by 35% compared to the previous quarter (Q3 2023, Q4 2023, Q1 2024 quarter-on-quarter growth rates were 70%, 70%, 67%). Although the growth rate has slowed down somewhat, the implied scale should have exceeded 40 million.

For the third quarter of 2024, the company is expected to perform weaker than Q3 2023 (i.e., less than 8.76 million). Although the market consensus is only 5.18 million, considering the 8 million increase in the relatively slow season of Q2, if Q3 also only has slightly over 8 million, some optimistic buyers may be disappointed.

The counter-seasonal trend changes in user numbers in Q2 and Q3 actually reflect a certain weakening of the benefits of combating account sharing and advertising users, especially the former. Originally, Netflix estimated that only about 100 million account sharing users could potentially be converted. Advertising users are expected to have further room for expansion in emerging markets

As expected, the major hit series in the second quarter is the third season of "Bridgerton" in the latter half of the season, along with "Baby Reindeer: Limited Series" and "Queen of Tears".

In the third quarter, Netflix's self-produced boxing show "Jake Paul vs Mike Tyson" will be launched, marking an important move for Netflix to accelerate its layout in sports content. In terms of series content, the third and fourth quarters are traditionally peak seasons for content, so the quantity will not be less. Therefore, although the company has provided guidance that did not exceed expectations, Dolphin believes that user growth in the third and fourth quarters is still something to look forward to.

In the medium to long term, the main logic remains the replacement of cable TV by streaming media, and Netflix's maintenance of its competitive advantage and leading position in the streaming media industry. According to Nielsen data, streaming media's viewership share in the second quarter has increased to 40%, reaching a new high.

II. North American User Growth Slows, Emerging Markets Return as Growth Drivers

In the second quarter, Netflix achieved a revenue of $9.56 billion, a year-on-year increase of 16.8%, with accelerated growth on a quarterly basis. The DVD business has returned to zero after the company announced its complete closure at the end of the third quarter.

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, there is no "superficial" price increase effect in terms of average revenue per user (ARPU). Except for Latin America, where ARPU can still grow slightly due to a significant price increase, ARPU in other regions has declined on a quarterly basis.

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

The company disclosed that in the markets where the ad-supported tier is implemented, the proportion of users choosing the ad-supported tier has reached 45% (up from 40% in the previous quarter), with a quarterly growth rate of 34% in ad-supported users. The market expects there to be around 40 million ad-supported users by the end of 2024.

Netflix expects advertising revenue to become a strong support for the company's revenue by 2025, with market estimates indicating that advertising revenue currently accounts for 3%-5% of total revenue. However, the monetization ability of advertising is highly correlated with traffic, so the company's current strategy of focusing on expanding user scale is the right direction. For example, replicating the routes of the UK, France, and North America, accelerating the phasing out of basic plans, and expanding the implementation of ad-supported plans in more regions.

Although it may temporarily lower the average ARPU per user, based on Hulu's experience, in the long run, the average revenue per user of ad-supported users will be higher than that of basic users, indirectly improving the company's monetization efficiency and profit margins However, Netflix needs to prove its advertising conversion rate by investing more in basic technology or collaborating with external advertising companies. After all, it not only competes with YouTube, but also faces competition from Google, Amazon, and others.

III. Short-term competition relief remains relaxed

Dolphin Jun has mentioned in several financial reports that the industry competition has slowed down for various reasons. For Netflix, which has content advantages, it is a definite dividend period. Dolphin Jun discussed this in detail in the fourth-quarter financial report review "Netflix: Content Dominator with a Strong Foundation, True Gold Does Not Fear Fire" last year, so I won't go into detail here.

In previous discussions, Dolphin Jun judged that Netflix will be in a comfortable zone throughout this year. After two quarters, the path and trend of user growth and profit improvement have even exceeded our expectations.

From Nielsen's data, it can also be seen that Netflix's viewing share has slowly climbed to a historically high level of 8.4%. For the upcoming peak season of content in the next half year, Dolphin Jun still believes that in the short term, Netflix will continue to maintain its competitive advantage and increase its market share.

However, in addition to traditional film and television giants, from the percentage of viewing time in the above chart, YouTube has also increased its share to 9.9%. Although there are significant differences in main functions/content for users between the two, whether in terms of competing for user time or considering some recent actions by YouTube around advertising on connected TV at home, it is expected that there will also be plans for professional film and television content investment in the future, indicating that there is an increasing competitive relationship between the two.

Netflix has also mentioned YouTube multiple times in its financial reports. In the second-quarter report, the company believes that because its high-quality content clips are widely distributed on YouTube, it is confident in its absolute advantage in professional content and hopes to continuously grab share in the total viewing time of "cable + streaming" which accounts for 80%.

IV. Accelerate content investment, cash flow affected

Netflix set a target of $17 billion in content investment for this year, spending $8.3 billion in the first half of the year, which is 49%. The investment scale in the second quarter increased by $800 million compared to the first quarter, reflecting that the size of content assets has begun to grow again instead of shrinking.

Increasing content investment can enrich the mid-term content reserves, but it will also have an impact on short-term free cash flow. In the second quarter, free cash flow was 1.2 billion, a 43% decrease from the previous quarter. Although the company continues to raise revenue and profit margin guidance, it has not raised the target size for full-year free cash flow (6 billion).

However, this should have been anticipated when the company set its investment target at the beginning of the year. For some funds that are valued based on cash flow, seeing a sharp decline in cash flow for the first time is inevitable.

Dolphin is relatively more positive about entering a new round of content investment cycle. The growth issues faced by peers in the content drought will be more challenging. Moreover, Netflix's high valuation is built on high growth. Without a high-quality and enriched content library as a support, using means to achieve customer conversion will only lead to user aversion, as seen in the past two quarters of Disney+.

V. Strict cost control leads to significant profit growth

In the second quarter, Netflix achieved an operating profit of 2.603 billion, a significant increase of 43% year-on-year, with a slight decrease in profit margin compared to the previous quarter, but a 5% increase year-on-year. Looking at the breakdown, the impact of increased content cost amortization on gross margin is significant, while operating expenses continue to be strictly controlled. Therefore, with a 17% growth in revenue, profit growth is maintained at a high speed.

In addition to strict cost control, Netflix's competitive advantage brought by its content strength also leads to higher profitability. With confidence in the content reserves for 2024, for three consecutive quarters, the management once again raised the operating profit margin target for 2024 from 25% to 26%.

Dolphin Research on "Netflix" Historical Articles

Earnings Season

April 19, 2024 Conference Call "Netflix: Focusing on User Interaction Metrics Rather Than Single User Numbers (1Q24 Conference Call Summary)"

April 19, 2024 Earnings Review "Netflix: Strong Now, But Will It Soon 'Collapse'? (1Q24 Earnings Review)"

January 24, 2024 Conference Call "Netflix: Expanding Content Investment, Using Content to Drive Price Increases (Netflix 4Q23 Conference Call Summary)" 2024 年 1 月 24 日财报点评《Netflix: Content hegemon with a solid foundation, real gold fears no fire》

2023 年 10 月 19 日电话会《Netflix: Hopes to return to the original investment level to drive growth (3Q23 earnings conference call summary)》

2023 年 10 月 19 日财报点评《Growth questioned? Netflix fights back with price hikes》

2023 年 7 月 20 日电话会《The impact of cracking down on account sharing will be further demonstrated (Netflix 3Q23 earnings conference call summary)》

2023 年 7 月 20 日财报点评《Netflix: Squeezed user growth, market skeptical?》

2023 年 4 月 19 日电话会《Focus on the prospects of advertising and account sharing fees (Netflix 1Q23 earnings conference call summary)》

2023 年 4 月 19 日财报点评《Difficult to crack down on freeloaders, Netflix, which is too familiar, can't "fly"》

2023 年 1 月 20 日电话会《Senior management changes do not hinder content strategy, advertising revenue target is above 10% (Netflix 4Q22 earnings conference call summary)》

2023 年 1 月 20 日财报点评《Hit dramas save advertising, Netflix perfectly interprets "content is king"》2022 年 10 月 19 日电话会《 Netflix: In addition to advertising, next year will focus on cracking down on account sharing (3Q22 conference call summary)》

2022 年 10 月 19 日财报点评《 Netflix: Facing adversity again, good content is the real "cure"》

2022 年 7 月 20 日电话会《 Advertising model is the new story of Netflix's future (conference call summary)》

2022 年 7 月 20 日财报点评《 Netflix: Performance didn't thunder, but the celebration is unnecessary》

2022 年 4 月 20 日电话会《 Focus on increasing revenue, actually "exposing" the lack of confidence in user growth (Netflix conference call summary)》

2022 年 4 月 20 日财报点评《 Plunging 25% overnight, Netflix's logic collapses》

2022 年 1 月 21 日电话会《 Management says guidance shortfall stems from pandemic-induced forecasting uncertainty (Netflix Q4 earnings call summary)》

2022 年 1 月 21 日财报点评《 Plunging 20%? Netflix becomes a copycat of iQiyi》

2021 年 10 月 20 日电话会《 Ambitious, Netflix's next goal is to learn from "Disney" (Q3 conference call summary)》

2021 年 10 月 20 日财报点评《 Netflix: The return of the streaming media leader, is it accidental or destined?》

2021 年 7 月 21 日电话会《 Netflix Q2 conference call summary》2021 July 21 Financial Report Review "Guidance Continues to be Conservative, When Will the King of Netflix Return After the Post-Epidemic Period?" at Dolphin Research

2021 April 21 Conference Call "Netflix Q1 Earnings Call Q&A: Check Out Management's Answers to User Growth Issues" at Dolphin Research

2021 April 21 Financial Report Review "After the End of the Epidemic Dividend Period, Netflix's User Growth is a Bit Bumpy" at Dolphin Research

In-depth

2022 February 16 In-depth "Battle of the Consumer Internet "Roll King", Meta, Google, Netflix Fighting with Bayonets" at Dolphin Research

2021 November 23 In-depth "Long Video Battle Coming "American Version", Netflix, Disney in Trouble?" at Dolphin Research

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