Freeloaders are hard to fight against, even the well-developed Netflix can't "fly".

On April 18th, Beijing time, Netflix released its Q1 2023 financial report. In the past quarter, Netflix has made some significant moves such as advertising, account sharing, and big price cuts in some regions. Therefore, the market is concerned about the actual impact of these operations on performance.

Overall, the effect is lower than expected. The advertising effect is not great, which was evident at the end of last year, but it is also related to the macro environment.

However, what needs to be mentioned is the paid-sharing plan launched to combat account sharing issues. In the short term, this may be met with user resistance, leading to a wave of cancellations.

Although Netflix has stated that the experience in countries and regions that have implemented paid-sharing shows that future user subscriptions will recover and bring in new subscribers, it will inevitably drag down short-term performance.

From the market's expectations, it seems that this impact has not been considered, coupled with the fact that Q2 is relatively quiet in terms of content, therefore, the company's performance guidance for Q2 will be lower than the current market expectations. Based on the "unsubscribe to resubscribe" trajectory of Canadian users, Q3 and the second half of the year are expected to have better results.

In addition, at the new investment cycle point, the decision to reduce content investment to maintain cash flow may also affect short- to medium-term content production.

Specifically:

(1) User numbers for the period and guidance are weaker than expected: Net user growth in Q1 was 1.75 million people, less than the guidance of 2.3 million, and some investment banks were even more optimistic. The Latin American region, where the expectation difference was greatest, may be related to the impact of price increases and the crackdown on account sharing, with an expected increase of 500,000 and an actual loss of 450,000.

The company expects Q2 subscriptions to be similar to Q1, but lower than the market's expectations (about 3.43 million). The guidance figure for user growth takes into account the short-term impact of implementing the account sharing plan in four new countries and regions (user resistance cancels subscriptions), and believes that the positive effects of the above measures will be evident in Q3.

(2) The expectation difference of user numbers leads to the expectation difference of revenue: In Q1, revenue increased by 3.7% year-on-year, excluding the exchange rate effect, the growth rate was 8%, and the month-on-month growth slowed down slightly, slightly lower than market expectations. The expectation difference in the number of subscription users is the main drag.

For Q2 revenue, the company's guidance is RMB 8.24 billion, a year-on-year increase of 3.4%, and a growth rate of 6% under unchanged exchange rates, which is significantly different from market expectations (about RMB 8.49 billion). Breaking it down further, both the number of user subscriptions and the amount paid by individual users are weaker than expected. I believe that the main reason is that the market has considered the short-term negative impacts of the account-sharing plan too little and slightly overestimated the effectiveness of advertising execution.

In addition, after years of steadily declining in the DVD business following the rise of streaming services, the company has decided to close completely by the fourth quarter of this year.

(4) Restrained marketing, profit beyond expectations: Although revenue did not exceed expectations, operating profit for Q1 was better than expected due to restrained marketing investment. However, due to the pressure on the revenue end relative to market expectations, the company's guidance for second-quarter operating profit was naturally weaker than expected. However, the full-year operating profit margin guidance is still in the range of 18-20%.

(5) Intentionally reduce content investment and release more cash flow: In the first quarter, FCF net inflows were 2.1 billion, which skyrocketed mainly due to the reduction in content investment expenditures, which was about 1.5 billion less than normal.

The previous content investment plan was 17 billion yuan per year from 2022 to 2024, which is expected to be reduced this year, so the net inflow target of free cash flow in 2023 was increased from 3 billion to 3.5 billion, and the investment target for 2024 remained unchanged for the time being.

But the embarrassing thing is, Netflix is approaching its new investment cycle. Will reducing the budget at this time affect the mid-term content output?

(6) After the cash flow is abundant, the debt pressure is lighter: At the end of the fourth quarter, the company's net debt (cash assets - long-term and short-term debt) was 6.7 billion, a decrease of 1.6 billion from the previous quarter. The first to mature is a priority note of 400 million that needs to be repaid in March 2024. However, due to the significant improvement in free cash flow, the short-term debt pressure is not high.

(7) Under the reserved base amount of cash, invest first and then buy back: In the first quarter, in addition to cash expenditures for operating purposes, the company continued to repurchase 1.2 million shares of company stock, consuming 400 million in cash. In the future use of funds, the company still chooses to reserve a basic amount of cash equivalent to about 2 months of income (based on Q1 revenue standards of about 5.4 billion yuan), and the excess part is used to repurchase company shares to return benefits to shareholders.

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Changqiao Dolphin's view

The most obvious problem in the first quarter report is that user growth is lower than expected, which is due to the market underestimating the short-term user loss caused by account sharing. Fortunately, competitors did not benefit much, so Netflix's content advantage is still as strong as ever.

But the problem arises again. As the new content cycle is about to come, Netflix's choice is to reduce the investment budget. Although reducing investment has indeed released considerable cash flow in the short term, it also has to make people worry whether the quantity and quality of content will be discounted after the budget is reduced, which also affects the solidity of Netflix's content barriers.

In the past year or two, the natural growth of Netflix subscribing users has been limited, and most of them rely on the drive of seasonal hot products. In the first quarter, Netflix sharply lowered prices in the Asia-Pacific region, especially the base version price, with a clear intention to lower the customer acquisition threshold and attempt to quickly increase penetration rates. But Netflix also said that this part of users currently has a very low actual revenue contribution. This means that the growth of these regions cannot support in the short term, but rely on the existing advantages to take the users first, and then cultivate long-term usage habits.

Therefore, we don't need to worry about whether these potential users can become new growth supports in the future for the time being. In the short term, Netflix's performance pressure is visible to the naked eye, and its dependence on explosive products is becoming more and more important. From a valuation perspective, it is currently in the neutral zone without an obvious safety cushion, and the holding experience in the fluctuation is poor, and the current participation value is not high.

Specific data of this earnings report

1. Account sharing plans were boycott in the short term, and user subscriptions did not meet expectations

Although Netflix’s content library was not weak in the first quarter, for example, the second season of "Ginny & Georgia" climbed the historical TOP10 list of plays, and seasons 1-3 of "Outer Banks" were very popular in March. At the beginning of the year, it officially launched an account sharing plan in the Latin American region, and then expanded it to four regions including Canada, New Zealand, Portugal, and Spain in early February. However, it encountered user resistance in the short term (account sharing among friends, extra charges for logging in from other regions), causing a "subscription storm" and a loss of users. Therefore, Netflix’s first-quarter user growth was 1.75 million, less than the market's expected 2.3 million.

As Netflix plans to expand the promotion of account sharing plans in the second quarter, including the United States, it is expected that the user growth in the second quarter will still be under pressure, but the market has not considered the impact of this, and the relatively shallow content library in the second quarter has led to a larger expectation difference. The company expects user growth to be similar to the first quarter, but the market expects it to be as high as 3.5 million.

However, the good news is that from the latest data in March, the impact in the first area to be promoted, Canada, is gradually weakening, and the number of users in March has begun to rebound.

The effect of driving user growth by advertising support services is also mediocre. This is basically consistent with the judgment in Dolphin Jun's point of view on last quarter's earnings report. Although the advertising-supported version can theoretically cover more user groups, ads still have an impact on the immersive experience of long videos. Therefore, the combined effect still depends more on the current explosive content, just like the account sharing plan.

Although the content was not weak in the first quarter ("Ginny & Georgia S2" and "The Glory S1" both topped the historical playback volume TOP10), it was still inferior to the previous quarter with "Wednesday" (Top2), thus causing greater pressure on users to advertising services and resisting account sharing.

Dolphin thinks that although it's good to be cautious in the short term, there's no need to be too pessimistic. Generally speaking, Netflix's content production is mainly in the second half of the year, and the first and second quarters are always the off-season, especially the second quarter. Historically speaking, as long as Netflix can produce good content, it won't have trouble attracting viewers.

In terms of regions, the main force of user growth this time is the Asia-Pacific and Europe, Central Africa, while the user base in Latin America declined in the first quarter.

1. Mature markets such as Asia-Pacific and Europe increased by 1.5 million and 600,000 users respectively;

2. North American users increased by 100,000, and Latin American users lost 450,000.

In the medium and long term, the company still expresses full confidence in the trend of "the traditional cable TV moving towards streaming media". According to Nielsen's data, the share of user time spent on streaming media in the United States in the first quarter is indeed increasing further. From December last year to February, it increased by 1.5 percentage points to 39.6% (including MVOD mode). However, the speed of penetration rate growth has slowed down to some extent.

However, the penetration rate of streaming media in countries such as Europe and Latin America is significantly lower than that in the United States, which also indicates that streaming media platforms such as Netflix, which are good at making content international, still have a lot of penetration space, and there is still industry dividend.

Second, large-scale price cuts for low- and middle-income regions.

In the first quarter, revenue was $8.16 billion, a year-on-year increase of 3.7%. Due to the high exchange rate of the US dollar, which accounts for 60% of Netflix's international revenue, the financial report data weakened the actual situation. Excluding the impact of exchange rates, actual revenue increased by 8%.

Looking at the subdivisions of the business, streaming media revenue (subscription + advertising) was $8.13 billion, a year-on-year increase of 3.9%, mainly driven by user growth. DVD sales declined as expected by 21%, and the company aims to completely shut down the business by the end of the third quarter of this year. In the first quarter, single user payment in subscription revenue continues to decline compared with the same period last year. The trend may continue in the short term, according to Dolphin. On the one hand, the increase of the advertising-supported plan users will lower ARPU. On the other hand, Netflix has implemented significant price cuts in more than 100 countries and regions, mainly in the Asia-Pacific region this year. Although Netflix stated that the revenue from the regions where price cuts were implemented accounts for less than 5% of the total revenue, it also revealed its intention to increase user activity in these regions. Dolphin believes that the North American market has become mature and has no natural growth, with seasonal fluctuations as the main factor. Therefore, short-term stimulation mainly relies on explosive content. Therefore, Netflix needs to tap into non-American user penetration to find long-term growth. In the current stage, it is not practical to increase prices to increase revenue for users in low- and middle-income Asia-Pacific regions. Lowering prices to attract more users is more beneficial. As shown in the picture below, the price cut mainly targets the basic version, and the standard and premium versions have relatively small changes. It also indicates that the main purpose of Netflix's price cut is to lower the threshold for acquiring customers quickly.

The third point: Streaming competition: Within the industry, they are doing well, and the erosion from outside the industry continues. Although Netflix mentioned the competitive impact of YouTube and TikTok in the financial report for the first time last quarter, they did not mention it this time. From Nielsen's data, the share of YouTube is still growing (from 8.7% in December last year to 9.1%), while Disney, HBO and other competitors directly compete with Netflix, and the overall share is temporarily stable.

Netflix's advantage is still the vast and relatively high-quality content reserves. Disney, Amazon, Apple TV, and HBO still need to fill the gap for the time being. Comparing Netflix with Disney, Disney lags as the follower in producing streaming content.

The fourth point: The investment cycle is approaching, but the budget for this year has been reduced. In the first quarter, the content investment expenditure was 2.8 billion, which continued to decline compared to the same period last year. Compared to the first quarter of past years, the investment amount decreased by 1 to 1.5 billion. Management revealed in this financial report that this year's investment budget would be reduced from the originally planned 17 billion, which also means that more cash flow will be released. Dolphin believes that due to the high interest rate environment, there is considerable pressure on global economic growth this year, with the US in particular bearing the brunt of it. Since 45% of Netflix's revenue comes from North America, reducing investments in a timely manner may be a relatively rational decision. However, abruptly halting investment at the inflection point of a new investment cycle may affect content output in the next 1-2 years. Dolphin is relatively cautious and needs to observe the situation continuously.

1. As of the end of the first quarter, Netflix's content asset size was 32.35 billion yuan, a decrease of 390 million yuan from the previous quarter.

1. In Q1, content investment spending was 2.8 billion yuan, and it will be less than 17 billion yuan for the whole year. At the same time, content amortization continues to accelerate with the increasing supply, and the accelerated depletion of content reserves will bring the inflection point of investment closer.

1. As of the end of the fourth quarter (performance briefings for the first quarter are not disclosed), Netflix's in-house content ratio exceeded 60%, but the size of in-house content assets has turned negative on a quarter-on-quarter basis. Considering the further reduction in overall content assets in the first quarter, the in-house content may continue to decline, which means that the demand for content supply is on a knife's edge.

5. Restrained marketing, profitability exceeded expectations

Q1 is not the peak season for content, so cost and expense spending is relatively low. Therefore, Netflix's profitability will be significantly restored compared to the fourth quarter of last year. Although Q1 revenue is under pressure, marketing expenses are lower than expected, so the final operating profit margin is 1% higher (actual 21% vs. expected 20% vs. guidance 20%).

However, as Q2 revenue faces greater pressure, the company's operating profit margin guidance for Q2 of 19% is weaker than the expected 21%.

The operating profit margin target for the entire year 2023 is still in the range of 18-20% (calculated based on the exchange rate on January 1, 2023). Considering the short-term revenue pressure, this means that there will be more actions to reduce costs and increase efficiency this year.

Dolphin Investment Research "Netflix" historical articles

Financial Reporting Season

Jan. 20, 2023 phone meeting “No impact on top management changes for content strategy, advertising revenue target of over 10% (Netflix 4Q22 phone conference summary)”.

Jan. 20, 2023 financial report review “Blockbuster drama saves ads, Netflix perfectly interprets the "content-oriented" concept”.

Oct. 19, 2022 phone meeting “Netflix: In addition to advertising, next year will focus on cracking down on account sharing (3Q22 phone conference summary)”.

Oct. 19, 2022 financial report review “Netflix: In the face of adversity, good content is the true "cure"”.

July 20, 2022 phone meeting “The advertising model is the new story of Netflix's future (phone conference summary)”.

July 20, 2022 financial report review “Netflix: Performance did not surprise, but there is no need to go overboard with celebrations”.

April 20, 2022 phone meeting “Focus on how to increase revenue, actual "exposure" lacks confidence in user growth (Netflix phone conference summary)”.

April 20, 2022 financial report review “Netflix collapses overnight by 25%, its logic crumbles”.

Jan. 21, 2022 phone meeting “Management says that guidance expectations were poor due to forecast uncertainty caused by the epidemic (Netflix fourth quarter phone conference summary)”.

Jan. 21, 2022 financial report review “Plummeting 20%? Netflix has become a copycat of iQiyi”.

Oct. 20, 2021 phone meeting “Ambition is high, Netflix's next target is to learn from "Disney" (third quarter phone conference summary)”.

Critique of Netflix's October 20, 2021 Financial Report: "Netflix: The Dominant Streamer Returns - Is it an Accident or Destiny?".

July 21, 2021 conference call: "Minutes of Netflix's Q2 Conference Call" and associated critique: "When Will the Streaming King Return in the Post-Pandemic Era with Continuing Conservative Guidance?"

April 21, 2021 conference call: "Netflix Q&A on Q1 Results - Check Out Management's Responses to the User Growth Issue'" and associated critique: "After the End of the Pandemic Windfall, Netflix's User Growth Slows Down a Bit."

In-Depth Analysis

February 16, 2022 in-depth analysis: "The Battle of the Consumer Internet 'Coupon King' is Heating Up, as Meta, Google, and Netflix Take up the Challenge."

November 23, 2021 in-depth analysis: "Is America's Answer to the Long-Form Video Battle Coming? Will Netflix and Disney Suffer?".

Risk Disclosure and Statement of this Essay: Dolphin Research Disclaimer and General Disclosure.