Netflix: The impact of cracking down on account sharing will be further demonstrated (3Q23 earnings conference call summary)
Below is the summary of Netflix's Q2 2023 earnings conference, and you can refer to the financial report review in "Netflix: Squeezed User Growth, Market Unconvinced?"
I. Management Summary
In May, we successfully launched the paid sharing feature, which now accounts for over 80% of our revenue in more than 100 countries.
(1) The revenue in each region is now higher than before the launch, and the number of registrations has exceeded the number of cancellations. The net paid additions in Q2 were 5.9 million, and today we are expanding the paid sharing to almost all remaining countries.
(2) The revenue for Q2 2023 was $8.2 billion, with an operating profit of $1.8 billion, which is in line with our expectations. We expect our revenue growth to accelerate in the second half of 2023 as we continue to promote the full completion of films and the stable growth of our revenue model. Our target operating margin for the full year 2023 remains 18% to 20%.
(3) We are the leader in streaming engagement. According to Nielsen data, in the first 25 weeks of 2023, we had the most popular original streaming series for 24 weeks and the most popular movies for 21 weeks in the United States.
Although we have made steady progress this year, we still need more efforts to accelerate growth. We remain focused on creating a constantly evolving must-watch content and movies, improving monetization capabilities, enhancing the enjoyment of our gaming experience, and investing in improving the services we provide to our members.
II. Q&A Analyst Questions
Q: Can you tell us about the actual impact of the two strikes on your business? How is the progress of your original content plans?
A: We do not want to have strikes, and we have been negotiating with writers, directors, actors, producers, and everyone in the industry. We really hope to reach an agreement now. I believe that the members of SAG (Screen Actors Guild) and WGA (Writers Guild of America) will not give up easily. We promise to reach an agreement as soon as possible, a fair agreement that allows the industry and everyone to move forward in the future.
Q: In terms of content, how much original content needs to be used up, for example, at a certain point in time?
A: We mentioned some upcoming content in the letter. As we mentioned in the last conference call, we have produced a large amount of content in various categories, including TV shows, movies, unscripted, scripted, local, domestic, English, and non-English. All of this is true. But the key is that we need to put an end to this strike so that we can move forward.
Password Sharing Related Questions
Q: Now let's talk about password sharing. Can you give us an update on the current situation, what progress you have made so far, and when will this rollout plan be completed? A: We spent a long time conducting repeated experiments to find a product experience that meets the needs of most consumers. We considered features such as transferring data and viewing records to a new account, easy management of devices and account access permissions, and the ability to purchase additional memberships for loved ones.
We believe that we have done well in building these features while also balancing user considerations to ensure that Netflix can receive reasonable compensation when providing entertainment to someone. Of course, we can invest funds to provide better service to everyone.
As of today, we have launched this experience in almost all countries/regions where we operate, and we see it making an impact. We are optimistic about both revenue and subscribers compared to our pre-launch in all regions.
Part of the reason is that these interventions are being gradually implemented, and part of the reason is that some users may not immediately register their accounts, but they may register when we release program titles that they are particularly interested in, whether it's in the next month, three months, six months, or even longer.
Therefore, we have launched this experience in the majority of countries, with over 90% of revenue coming from these countries, and we will continue to iterate and execute this model.
Q: Can you provide some information about the results, such as the percentage of conversions to paid plans? And how many new members and subscribers are there? Although the number of subscribers this quarter is good, the family add-on feature has also played a role. Can you explain who changed their plans?
A: Overall, what we see is that these users are high-quality members who choose to use and retain the service similar to long-term members. This is a general approach to thinking about the composition of these borrower groups. Additionally, this is consistent with the fact that we first convert those borrowers with the highest engagement and qualifications. This is a general consideration for this issue. Besides that, I won't comment on more specific numbers.
Q: Perhaps you can help us think about how much of the growth in ARM (Average Revenue per Member) in the UCAN (United States and Canada) region is the result of existing accounts adding members and new subscribers signing up for higher-priced plans. From the letter, it seems that as the impact of password sharing further decreases, ARM will accelerate its growth in the second half of the year. Is that correct?
A: Maybe we can broadly consider our revenue situation in the second quarter and beyond. This is our main goal to accelerate revenue growth, and we are ready to deliver.
However, if we review the revenue growth and composition of the overall or specific regions, they are driven by a combination of pricing, user numbers, and new revenue streams such as advertising. If we consider each driving factor, it has been over a year since we made any price adjustments in major revenue countries. During the launch of our paid sharing feature, we basically suspended price adjustments, which was expected.
Therefore, most of our revenue growth this year comes from the increase in the number of new paid members, which is mainly driven by the launch of our paid sharing feature. Paid sharing is the main driver of our revenue growth this year. As Greg mentioned, we expect its impact to gradually strengthen in the coming quarters. This is what we see in each region and in the UCAN region. The UCAN region benefits more because of the larger advertising market, but overall it is still very small as it is still in its early stages for our business.
Q: But you had a surprising development in the past few weeks that seems to be a very positive driver for ARM, which is the discontinuation of the base plan in Canada a few weeks ago, and the announcement that the same measure will be taken in the United States and the United Kingdom. Do you have plans to implement the same strategy in other regions, and based on your experience in Canada, has this strategy achieved the desired effect? Did more people choose the ad-supported plan? Secondly, I feel that the impact may exceed $5 per month. When this plan is fully rolled out over the next three years, when do you think it will have the greatest impact?
A: Certainly. We believe this is a continuation of what we have been doing for a long time, which is considering how to optimize plan structure, pricing, and features, with two main objectives.
One objective is to provide consumers with a wide range of price options, which means appropriate price ranges and corresponding futures, including advertising, ad-free, video quality, and the number of simultaneous streams (playing different content on different devices), etc. We will also try to increase these features in the future.
The second important objective is to optimize long-term revenue, which includes a range of factors you might think of, such as sign-up conversion rates, plan distribution, engagement, and retention. As we evolved from a single plan a few years ago and adjusted our product over time, this latest move reflects what we believe is the best way to achieve these goals in countries like the United States, the United Kingdom, and Canada.
Furthermore, I think it's worth noting that from the perspective of accessibility and affordability, we believe the entry prices (ad-supported plans) in these countries are very attractive: $6.99 in the United States, £4.99 in the United Kingdom, and $5.99 in Canada. These prices represent amazing entertainment value and have attracted a large number of registered users.
As for the specific impact: when we discontinued the base plan, people who were planning to subscribe to that plan would choose one of the two plans. They either choose the lower-priced ad-supported plan or upgrade to the standard plan. We have seen this rearrangement in that regard. As for our expectations, we are gradually rolling out this plan to understand its impact and avoid unexpected consequences, and overall it aligns with our expectations. Q: But is there a noticeable difference in unsubscribing for your new members or subscribers obtained through password sharing?
A: The way we see it in terms of signing up members and borrowers who are now unsubscribing, we should consider them as qualified users. They are long-time Netflix viewers who understand how Netflix works. Therefore, in terms of retention and sharing characteristics, their behavior is similar to that of subscribers with longer rental periods, which means better customer retention rates.
Some of the questions you asked may involve ARPU (Average Revenue Per User), which we refer to as ARM (Average Revenue Per Member). So, what do we see in the numbers? Taking into account the impact of the basic ad-free plans being phased out in Canada and several other countries, as well as the impact of building our advertising business, let me explain a little more. If we start with the revenue-driving factors we discussed earlier, this is mainly due to the pre-launch of paid sharing in major revenue markets over the past year.
Additionally, there are also factors related to changes in plans and country mix. Therefore, these factors will have an impact on the ARM trend. But it is important to note that over time and in the medium to long term, we expect ARM to benefit from price adjustments. We have not changed our long-term pricing strategy, and ARM will benefit from advertising and the new members you mentioned. It's just that both of these factors are still in the early stages.
Even with the measures we just mentioned, only a small portion of members choose the ad-supported plan, and although the ad-supported plan is growing rapidly, the base is still small. As for the impact of paid sharing, this factor will gradually increase due to the accumulation of multiple quarters. Over time, we expect all these factors to be reflected in the growth of ARM.
Advertising-related questions
Q: Next, I have some questions about advertising. Can you provide some information about the innovative or non-traditional forms of advertising that you have? I mean, you mentioned earlier about the ability to offer advertisers access to the top ten, which provides incredible coverage and ensures that ads appear every moment.
A: Yes. I think going back to what we were just talking about, it is necessary to start with business growth. We know that coverage is one of the main considerations for advertisers when deciding where to spend their advertising budget. We want to be in the top tier, which is a good growth trend, as Spence mentioned. We want to continue this growth trend. So that's the first task.
The second task is that we have a range of non-innovative features for our advertising clients, which follow a rigorously validated path. We are rolling out these features. These include verification, measurement, and targeting. I also want to include in that, establishing our marketing and sales capabilities in each country so that we can serve more advertisers and provide them with more effective services. So, there is a lot of very straightforward work to be done, all following traditional methods. We just need to focus and execute according to the plan. Next, let's talk about the topic you mentioned, which is to truly consider our advertising business over time and integrate TV attributes into digital advertising, as well as work between user experience and ad experience. This truly leverages the fundamental capabilities we have been using for a long time, including user experience testing, iterative development, and data-driven personalization. Over time, we have established a leadership position in defining a high-quality CTV advertising experience.
You mentioned the top ten, and I think this is a creative way of thinking that allows us to provide advertisers with different ways to participate in the most popular shows and movies on Netflix. It's exciting. But we still have a lot of work and opportunities ahead of us, and we are very focused on continuous improvement. We also believe that all the foundations have been laid and we can build a significant advertising business in the coming years.
Q: In the previous quarter, you mentioned that the advertising ARM is at least on par with the standard plan, indicating that the advertising portion is at least $8.50 or higher. Has there been any change in the advertising ARM?
A: There hasn't been any change. Similar to the standard plan, advertising revenue is higher than the basic ad-free plan in the United States. Overall, we are satisfied with the advertising economics per member and remain optimistic about increasing advertising plans and expanding the advertising business, which benefits both members and our business. But as Greg mentioned, we have a lot of work to do to move from the current state to the future, and we believe it will become an important additional revenue growth and profit-driving factor for the company.
Q: Can you talk about the initial performance of Netflix's presold ads? I mean, you seem to have everything advertisers need. However, the overall advertising market environment is relatively sluggish. So, can you give us some insights or feedback received on the current situation?
A: First of all, it's great to be able to meet with so many advertisers in a short period of time and hear what they need. This helps us identify the content they most need and how we can better support these advertisers.
However, currently, we benefit from having a smaller scale, and our ad inventory is relatively scarce. I think we are able to manage this process effectively and see good demand and progress in presales in this broad and sluggish market environment.
But our current focus is really on increasing ad capabilities as quickly as possible to meet the needs of advertisers, making our product more attractive while increasing ad inventory.
Q: What tools and time investment are needed to build your own ad tech infrastructure?
A: This is an incremental process. If you're looking for specific numbers, we currently have dozens of engineers working on this issue. They are constantly delivering new features. Microsoft even has more people continuously delivering features. Our collaboration with Microsoft is prioritized and implemented based on the needs of advertisers, step by step.
Q: Do you have a timeline for achieving scalability, such as planning to have all the technical capabilities within three years? A: The scale of coverage and advertising technology capabilities is not a binary state. It's not something you have one day and suddenly possess the next day. Therefore, I believe we are constantly iterating and improving in these two aspects. In terms of scale, we have achieved a quarter-on-quarter growth of 100%, which impresses me. This is a good growth trajectory that puts us in a good position and makes us better every year. As for technological features, we have a long list that is not easily completed all at once. However, making progress in our current work allows us to transition from infrastructure construction to the innovative space you mentioned earlier.
Q: How do you view the contribution of the advertising business? But considering the decline of linear advertising, are you reconsidering this proportion to make it higher?
A: Therefore, we don't want to invest more resources prematurely. We need to do a lot of work and preparation. We believe it can become an important part of our business. When we say 10%, it's because if we don't think it can generate at least 10% of the revenue, we wouldn't put in so much effort, time, and resources to promote and invest in personnel management, like Greg, Ted, and other senior executives. So, I think it's a goal we hope to achieve or surpass in the future.
As you said, we believe we are a good ecosystem and environment to gather this demand, but we need time to prove it. Therefore, we are not ready to make long-term predictions based on goals that have never been achieved before, and we need some time to prepare and achieve them.
Q: Perhaps I can follow up on what you just said. Over time, where do you think the advertising funding pool will come from? Considering all the capabilities Greg just mentioned, why is it limited to linear advertising? With such outstanding capabilities, shouldn't the funding pool include both linear and digital advertising?
A: I think it can be said, but for now, this is the hot area we can currently address. We are building capabilities and aspiring to expand our coverage. But our top priority is pursuing brand advertising. There is a lot of funding involved. There is a lot of funding looking for high-quality users to connect with, and we believe we can provide such a solution.
Q: Has there been any change in user engagement in the past quarters? Are there significant differences between users of different packages?
A: Generally, you might expect differences between users of different packages, such as higher qualifications and engagement usually meaning higher-priced package participation. But if that's what we want to achieve, we haven't seen any changes over time. Therefore, we see good user engagement across all our package levels and good engagement in advertising campaigns.
Currently, it occupies 37% of TV viewing time in the United States. And we continue to increase our streaming market share in this rapidly growing field, despite intense competition. The best evidence is that almost every week this year, we have had the top-ranked TV shows and movies on streaming platforms. This creates a plethora of opportunities, as you mentioned, but all these opportunities rely on us building these capabilities.
With more and more attention shifting towards streaming, there is a tremendous opportunity. Users are turning to streaming because it aligns with consumer demand. We didn't invent something and then make them use it. Essentially, consumers have moved away from the era of linear schedules dictating where and how they can watch their favorite content, and we need to meet their demand for high-quality streaming and content.
We achieve profitability through pure subscriptions and advertising, which entirely depends on us having content that users love and providing it day after day, week after week, in every country. Ultimately, the foundation of attracting advertisers is our reach, high engagement, and stunning titles, TV shows, and movies, as mentioned by Ted, the top-ranking content that makes them want to showcase their brand alongside it.
Cash Flow-related Questions
Q: So let's talk about free cash flow. You had exceptional performance this quarter, and you mentioned the outlook for Q3. Can you discuss potential dynamic factors? Talk about content spending and other investments?
A: In our cash flow forecast, we made adjustments for 2023 to reflect our expectations of growth. This is primarily driven by a few factors. First, with the early success of paid sharing, our forecasts are more certain. We also made some adjustments in terms of timing. The expected free cash flow for 2024 is still significant, but there is some volatility between years.
Overall, over the next few years, we expect a positive and growing trajectory of free cash flow, but there will be some short-term fluctuations. We have gone through the most capital-intensive phase of our original programming strategy. Taking a multi-year perspective, we plan to manage expenses reasonably, aiming for a growth rate slower than revenue, which helps us scale healthily.
Q: What are your views on the content spending outlook for the next few years? Will it return to normalcy after multiple strikes?
A: When our revenue slowed down in early 2022, we mentioned that we would maintain cash content spending roughly flat. From 2022 to the planned year of 2024, we have been executing such a plan, partly due to the impact of the COVID-19 pandemic, as we discussed. Recent strike issues have also contributed to this volatility.
So we hope to achieve growth and return to those levels next year. As we mentioned in the letter, it's about a 1.1x ratio of cash content spending relative to our content spending. This allows us to scale healthily while gradually increasing cash flow over time.
However, we must prove this first, of course, and we want to offer more exciting entertainment content to our global members. We believe we have many opportunities to invest more and embrace significant market opportunities, but we want to manage these funds responsibly. We believe that our business model will continue to have significant leverage and growth potential after 2024. As we continue to expand our subscriber base and improve content supply, we expect to achieve revenue growth and cash flow generation.
In addition, we are also investing in areas such as advertising technology capabilities and international expansion to further drive our growth. As we scale, we may benefit from economies of scale and other efficiencies, which will help us generate positive free cash flow in the long term.
Overall, we remain confident in the strength and sustainability of our business model and our ability to create value for subscribers and shareholders.
Q: But if your content spending is very restrained, then you may invest in advertising technology capabilities. However, besides that, your business model seems to have a huge impact. Is there a way for me to think about growth and free cash flow after 2024?
A: I think the best way to think about it is that we expect revenue and profit growth over time. We have already passed the most capital-intensive phase of spending. And based on the current plan, we will maintain this level in the foreseeable future.
Therefore, I think this can provide you with the right foundation to have a rough sense of future development. I believe you will see that this will bring about very healthy free cash flow generation for the foreseeable future.
Q: Can we talk about the use of free cash flow and possible mergers and acquisitions? I mean, there are many distressed assets in the media industry, and their valuations may be at historically low levels. Which assets might you be interested in?
A: We always look at these assets from the perspective of intellectual property opportunities, and some assets are in distress because of certain issues. Therefore, our main focus is to find intellectual property in M&A activities that can be developed into high-quality content, which is also the true strength of our business.
So, I think we are traditionally better at building our own strength rather than acquiring well-known brands. But if there is an opportunity for us to acquire a large number of intellectual property rights that can be further developed and built, it will also be very attractive to us.
Q: But you already have a huge content library of over 10 years and some stunning global titles. So, would you consider selling your inventory content to others?
A: We have always believed that the content we offer to members on Netflix is unparalleled in value. And putting it anywhere else may have cross-platform issues because the viewership on other platforms is much smaller.
Therefore, continuing to have our content play on Netflix, even after the original run, is the right path for us. Currently, the remaining TV broadcast market and home video market are shrinking in a less exciting way, contrasting with the opportunities we are rapidly developing. By providing content to our members, we have the opportunity to inspire and meet their needs, and looking back at the history of our content, it is also a very important part of our content library. We have also noticed that when "Saving Cartel 2" performed well in the previous quarter, "Saving Cartel 1" immediately returned to the top ten. This situation often occurs when "Charlotte Queen" enters the top ten and new programs are aired. Therefore, this is a very fluid and dynamic situation, and as our content library becomes deeper and richer, the situation will only get better.
Q: Can you talk about Netflix's strategy, including testing sports programs? I mean, it seems like a lot is happening in the sports area, and you seem to have outperformed ESPN with "The Last Dance" and NFL sports documentaries. So, if you can discuss live sports, that would be great.
A: Our position in live sports remains unchanged. We are very excited about the success we have achieved with sports-related programming. Recently, we launched a program called "Quarterback" in collaboration with the NFL. A few weeks ago, we aired the Tour de France, which, like "The Amazing Race," introduces a sport that has been around for a long time and is not well understood through excellent storytelling.
In this way, we can provide fans of various sports with a variety of sports programs that have seasons throughout the year, leaning towards our strength, which is storytelling. Therefore, we are very excited about this. You may have also seen that we are going to experiment with some new content, such as live coverage of a golf tournament in November. We are very excited about this because it not only provides a promotional channel for our sports brands like "Full Sprint" and "The Amazing Race," but also allows us to provide a stronger service to Netflix's sports fans without the economic challenges of acquiring live sports rights.
