Blockbuster dramas save advertisements, Netflix perfectly interprets "Content is King"

Netflix released its financial report for the fourth quarter of 2022 in the early morning of January 20, Beijing time. The overall performance was impressive thanks to the popular dramas. The main areas that exceeded expectations were the growth in subscription numbers and profit margins. In terms of guidance for the next quarter, the revenue side is consistent with market expectations, while the operating profit margin is slightly weaker.

Specifically:

(1) In the fourth quarter, total revenue increased by 1.9% year-on-year, with exchange rate effects excluded, the growth rate was 10%. This is mainly due to the large increase in subscription users driving growth. The guidance for the next quarter is 8.17 billion yuan, an increase of 3.9% year-on-year, and a growth rate of 8% with exchange rates unchanged, basically in line with market expectations.

(2) There were 7.66 million net additions of users in the fourth quarter, greatly exceeding the guidance of 4.5 million. The user growth in mature regions such as Europe and America exceeded market expectations. The Dolphin Analyst believes that the rebound of users in mature regions such as Europe and America is not closely related to the introduction of advertising-supported services, but more driven by popular dramas such as "Wednesday".

Last quarter, Netflix management stated that after launching advertising-supported services, it will focus more on overall revenue growth rather than net additions of subscription users as a single indicator in the future, so it will no longer provide user growth guidance starting from this quarter.

Market expectations for net additions in the first quarter of 2023 are 3.5 million, and the Asia-Pacific region is the main force driving growth, contributing nearly 40% to the increment.

(3) The profit margin weakened seasonally due to more content in the fourth quarter, but it was higher than guidance and expectations. The main expectation gap is in expense spending, and the company's actual expenses are lower than expected. The company is more optimistic about the guidance for the operating profit margin in the next quarter and 2023, basically following a steady upward trend.

(4) The net free cash flow in the fourth quarter was 332 million yuan, which means that the total inflow in 2022 was 1.6 billion yuan, exceeding the guidance of 1 billion yuan.

The company's guidance for free cash flow in 2023 is 3 billion yuan, and it is expected that the advertising business with a more favorable business model will be the main driving force for growth.

(5) At the end of the third quarter, the company's net debt (cash minus long-term and short-term debt) was 8.3 billion yuan, an increase of 400 million yuan compared to the previous quarter. The earliest maturity date is a 400 million yuan priority note that needs to be repaid in March 2024. There is not much short-term (12 months) debt repayment pressure, which will not have a significant impact on cash flow.

In addition to cash expenditures for operations this quarter, the acquisition of two animation and game studios (Animal Lgic, Spry Fox) was also completed. In terms of future use of funds, the company will use the excess part of the two-month revenue cash beyond operating needs to acquire new targets and buy back company shares to feedback shareholders.

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Dolphin Analyst Opinion

In fact, the market expectations experienced a lot of ups and downs in the fourth quarter, from "optimistic expectations for advertising services," to "lowering expectations for actual online distribution after a month of poor results," to the "surprisingly positive reactions to hot dramas such as Wednesday and The Crown S5 in November," and to "the favorable impact of the weaker USD on the pricing of international business, which accounts for 60% of revenue, thereby reducing foreign exchange losses" and once again maintaining optimism for the fourth quarter and 2023 for Netflix.

Dolphin Analyst believes that the core reason for the volatility of expectations lies in the complexity of the current environment. The changes in the expected macroeconomic downturns make it difficult to assess the effectiveness of Netflix's subscription consumption and advertising revenue. However, due to Netflix's remarkable content advantage, its streaming status is difficult to shake in the short term compared to its peers.

However, the medium- to long-term prospects are still ambiguous. On the one hand, the industry dividend-the substitution of streaming media for traditional cable TV-will continue for a period of time, and Netflix will clearly benefit from this. On the other hand, competitors may narrow the gap with Netflix as they continue to invest in filling content gaps. In addition, Nielsen data shows that compared to its long-content peers, YouTube has been rapidly increasing its user time share for nearly a year, and competition from potential short-video platforms such as TikTok also needs to be consistently monitored.

Implying the growth trend of advertising revenue for this year, Netflix raised its operating profit margin target for the year. This is a positive signal that the company has high confidence in the effectiveness of its advertising support plan and paid shared accounts, despite macroeconomic pressure this year. If the market expectations are also raised accordingly, the current valuation corresponds to a 2023 PE performance of about 25-30 times, which is within a reasonable range but historically located in the lower-middle region. After the good news from the financial report is released, there is short-term upward potential for valuation.

However, given the economic data of the last two days, the Dolphin Analyst believes that it is still necessary to evaluate the possibility of the depth of the U.S. macroeconomic downturn, which cannot be ignored regarding the impact on terminal consumption and advertising investment willingness.

Specific Financial Report Data

1. Record-breaking hits; user subscription vastly exceeds expectations in third quarter.

Riding on the success of Stranger Things in the third quarter and relying once again on explosively popular TV dramas, the recently launched Wednesday in November became the second most-watched English show in history. Although the advertising-supported services launched in 12 countries around the world played a role in driving user growth, considering previous guidance (440,000 advertising users) and regional distribution of user growth (mature markets with lower sensitivity to advertising packages showed a greater increase in subscriptions), Dolphin Analyst believes that the primary driver of subscription growth surpassing expectations this quarter still comes from the hit content.

Regionally, the Asia-Pacific is still the main driver of user growth, but the strong demand of European and American users is an unexpected phenomenon in the market. (1) In mature markets such as North America and Europe, the number of users increased by 900,000 and 3.2 million respectively, mainly driven by the popular dramas "Wednesday" and "Glass Onion".

(2) The Asia-Pacific and Latin American markets have been responsible for most of the user growth in recent years, with an increase of 1.8 million and 1.76 million respectively.

Guidance for the next quarter: Starting from the fourth quarter, Netflix will no longer provide guidance on user subscription growth, but it has revealed that there will be "moderate growth" next quarter, rather than net user loss as in the first quarter of 2022. After the launch of advertising services, the synchronous growth relationship between user subscription indicators and overall revenue weakened. Therefore, the company pays more attention to the overall revenue situation and uses revenue scale as the main target consideration.

Market expectations show that the expected number of new users in the next quarter is about 3.5 million. Based on the performance of the fourth quarter and if season 4 of "You" is released on schedule, Dolphin Analyst believes that net user subscriptions may still exceed expectations.

For advertising package user situation, this quarter's financial report did not do a detailed breakdown disclosure. Netflix's official short-term goal is to reach 4.4 million for the whole of 2022. Considering that the news earlier showed that the distribution effect of advertising in the fourth quarter was not good, which is to say that advertising users did not meet expectations, so it is reasonable to expect that the number of advertising users is below 4.4 million. Deducting this from the 7.66 million new subscriptions, it is likely that the real new subscription situation of the original package has increased compared to the previous period, and it is much better than previously expected.

In addition to advertising support services being the main driving force for user growth in some regions, in 2023, Netflix will begin to focus on attacking the potential losses of paid subscriptions caused by account sharing behavior. Therefore, we expect that the effect of user subscription growth will be most pronounced in the second quarter of the financial report.

In the long term, the company is still confident in the trend of the migration of streaming media to traditional cable TV. The fact is that the user time-share of American streaming media further increased in the fourth quarter, from September to November, it increased by 3%, reaching 38.3%. The penetration rate of streaming media in Europe, Latin America and other countries is lower than in the United States, which also indicates that there is still considerable penetration space for Netflix and other streaming media platforms, and the industry dividend is far from over. In Q4, Netflix achieved revenue of US$7.852 billion, a year-on-year increase of 1.9%. Due to the high US dollar exchange rate, the financial report data weakened the actual situation for Netflix, whose international income accounts for 60%. Excluding the impact of exchange rates, actual revenue increased by 10%.

Looking at the segmented business, streaming revenue (subscription + advertising) was US$7.818 billion, a year-on-year increase of 2%. Under the same exchange rate, the growth rate should exceed 10%. DVD sales were down 20% as expected.

The main driver of the total revenue in Q4 comes from the growth of user subscriptions. Single-user payment decreased month-on-month, and after excluding the impact of exchange rates, it was mainly due to the average payment decrease in Europe, the Asia-Pacific region, and other countries such as Japan and South Korea, which indicates that the willingness of users in these areas to accept ad-supported services is higher. Meanwhile, users in the U.S. and Canada, which are still growing year-on-year, have weaker feelings toward advertising services.

In Q4, Netflix mainly raised the user subscription prices in Argentina, while there was no significant price hike in other regions, which may be due to the continuous depreciation of the Argentine peso. Competitors such as Disney+ and Apple TV+ are intensifying their pricing in the U.S. in the hope of further improving their profit model.

Regarding streaming competition, the short-term threat of peers is limited, and competition outside the industry is worth paying more attention to.

Last quarter, Netflix disclosed its user data compared with two direct competitors, Amazon and Disney, in its financial report for the first time. Perhaps it was too straightforward, or perhaps it was because the short-term threat of competition was limited, this financial report did not make direct data comparison again.

According to Nielsen's monthly data, Netflix's share of viewing time gradually decreased from September to October before the launch of "Wednesday" in November, and rebounded significantly after the launch of "Wednesday." However, during this period, the biggest impact on Netflix was not from peers (Disney, Amazon, but HBO's short-term momentum was a bit fierce), but YouTube and other streaming platforms.

This is mainly due to Netflix's short-term absolute advantages in content reserve, while Disney, Amazon, Apple TV, and HBO still need to make up for the shortcomings.

For example, comparing Netflix with Disney, in the period from September to December last year, Netflix's superior historical reserve enabled it to quickly launch in bulk in various versions, but the increase in films in other regions of Disney+ was far less than that of Netflix except for the newly entered Southeast Asia and India.

Netflix highlighted the names of YouTube and TikTok in its financial report. YouTube's increase in overall streaming time share almost coincides with its launch in Shorts and the official commercialization of Shorts.

In other words, the power of Short videos' traffic black hole has also become a common problem for global long videos, even if the content is as strong as Netflix's.

Advertising is an important move for Netflix, and gaming and consumer products based on film and television IPs are also the company's key focus, especially after the success of Squid Game merchandise. Currently, Netflix has a product portfolio of 50 games and plans to further expand its offerings, especially by integrating Netflix's own IPs with games. Currently, gaming and consumer products cannot provide significant support for the company's performance.

Fourth, the acceleration of existing content reserves is expected to return to the investment period soon.

Cash spending on content investment in the fourth quarter was only 3.7 billion, totaling 16.6 billion for the year, less than the target of 17 billion. This is probably due to expectations of economic pressure.

However, after another peak period of content supply in the fourth quarter, existing reserve contents are also rapidly decreasing, and the scale of content assets has turned negative on a month-on-month basis. The decline in year-on-year content investment continues to deepen from the previous quarter, and a new inflection point for investment period is approaching.

1. As of the end of the fourth quarter, Netflix's content assets were worth 32.7 billion, a decrease of 4 million (yuan?) on a month-on-month basis.

1. In the fourth quarter, content investment was 3.7 billion, totaling 16.6 billion for the year, and the original budget of 17 billion was not fully utilized. At the same time, content amortization continues to accelerate with increasing supply, and the accelerating depletion of content reserves will make the inflection point for investment period even closer.

1. As of the end of the third quarter (the fourth quarter performance report is not disclosed in the interim report), Netflix's in-house content accounted for more than 60%.

4. Management steadily raises 2023 profit margin expectations

In general, the fourth quarter is Netflix's peak content production season, corresponding costs and expenses gradually increase. In addition, the biggest increase in sequential growth comes from sales costs due to advertising support services. However, the actual expenses incurred by the company are less than the market's expectations, therefore, the final operating profit margin is 2 percentage points higher (actual 7% vs expected 5% vs guidance 3%).

The operating profit margin for the full year 2022 was 18%, and after excluding the impact of exchange rates, it was 20%, basically achieving the mid-year guidance target. The management team proposed that the expected operating profit margin for 2023 will be 21%-22% (without changes in exchange rates), which is slightly higher than the original target of 19%-20%. Although the macro pressure this year is visible to the naked eye, the company's confidence in the operating level is still strong, especially for advertising revenue with a high gross profit margin.

(This part ends here)

Dolphin Analyst's historical articles on Netflix

Earnings Season

October 19, 2022 Conference Call: "Netflix: In addition to advertising, next year will focus on cracking down on account sharing (3Q22 conference call record)"

October 19, 2022 Earnings Review: "Netflix: Reversing the bearish trend again, good content is the real medicine"

July 20, 2022 Conference Call: "Netflix: The advertising model is the new story of the future (conference call minutes)"

July 20, 2022 Earnings Review: "Netflix: Performance without thunder, no need to excessively celebrate"

April 20, 2022 Conference Call: "Focus on how to increase revenue, in reality, "revealing" a lack of confidence in user growth (Netflix conference call minutes)"

April 20, 2022 Earnings Review: "Netflix collapses overnight, logic crumbles" Dear all,

Please find below the Dolphin Analyst's reviews on Netflix's financial reports and conference calls:

• Telephone meeting on January 21, 2022: "Management said that the guidance gap was due to the uncertainty of forecasts caused by the epidemic (Fourth Quarter Report conference call minutes)."
• Financial report assessment on January 21, 2022: "Did Netflix plummet 20% and become a copycat of iQiyi?"
• Telephone meeting on October 20, 2021: "Netflix's ambitious next target is to learn from 'Disney' (Third Quarter Conference Call Minutes)."
• Financial report assessment on October 20, 2021: "Netflix: The streaming media giant's return to dominance, a surprise or destiny?"
• Telephone meeting on July 21, 2021: "Netflix's Second Quarter Conference Call Minutes."
• Financial report assessment on July 21, 2021: "Will Netflix, the king of the post-epidemic period, return soon? | Dolphin Analyst."
• Telephone meeting on April 21, 2021: "Interview with the management of Netflix in the First Quarter Conference Call on the issue of user growth."
• Financial report assessment on April 21, 2021: "After the epidemic dividend period, Netflix's user growth has declined a bit."

In addition, the Dolphin Analyst has written two in-depth articles on Netflix: "The competition among consumer internet 'coupon kings', Meta, Google, Netflix, etc." and "A fierce battle of long videos is coming, is it the 'American version', Netflix and Disney are in trouble?" Please be advised that the risks and disclaimers for this article can be found in the Dolphin Analyst's disclaimer.