After-hours surge of 13%! How impressive is Netflix's Q3 earnings report?

After the US stock market closed on October 18th, the streaming giant Netflix released its third-quarter earnings report for 2023. Due to better-than-expected results, the company raised its fourth-quarter profit margin expectations and announced price increases in the US, UK, and France. As a result, the stock price rose more than 12% after hours.

Before the earnings report was released, Netflix's stock price fell 2.7% to a five-month low. Over the past three months, the stock has fallen by about 20%, underperforming the S&P 500 index's decline of 2.7% during the same period. However, it has risen more than 17% this year, outperforming the S&P 500's gain of about 14%.

The stock has fallen more than 40% from its all-time high of $610.34 on June 30, 2021, during the pandemic period. This decline is partly due to the revaluation of large-cap tech stocks during the interest rate cycle, and disappointment with the company's cautious attitude towards profitability and growth.

Among the 48 analysts surveyed by FactSet, 24 rated the stock as a buy, 22 rated it as a hold, and only 2 recommended selling. The average target price is close to $448, representing a potential upside of nearly 30%.

Netflix's third-quarter earnings were optimistic, with free cash flow reaching the second-highest level in history, and a significant increase of 8.76 million new subscribers, second only to the peak of the pandemic.

The company's revenue for the third quarter was $8.54 billion, a year-on-year increase of 7.8%, which was in line with expectations. Earnings per share (EPS) were $3.73, a 20% increase from the same period last year's $3.10, and higher than the market's expected $3.49.

The operating profit margin for the quarter was 22.4%, a 3 percentage point increase from the 19.3% in the same period last year, and higher than the market's expected 22.1%. Operating profit was $1.92 billion, a 25% increase from the expected $1.9 billion. Free cash flow was $1.89 billion, compared to $472 million in the same period last year, exceeding the market's expected $1.27 billion, and reaching the second-highest level in quarterly history.

The most notable achievement is the significant increase of 8.76 million net new subscription users globally, compared to 2.41 million in the same period last year. This far exceeded Wall Street's expectation of 6.2 million and set a new record for the largest quarterly net increase since the peak of the pandemic in the second quarter of 2020.

This has led to a year-on-year growth of 11% in Netflix's total paid streaming members to 247.15 million, surpassing the market's expected 243.88 million. At the end of the second quarter, the total number of subscribers exceeded 238 million. Among them, the net addition of users in Europe, the Middle East, and Africa is close to 4 million, the highest number among all markets. The net addition of users in other markets has exceeded expectations, with a 31% YoY growth in the Asia-Pacific region.

The subscription volume of ad-supported packages has increased by nearly 70% MoM, highlighting the industry's leading position in major markets such as the United States, the United Kingdom, and France

Some analysts pointed out that Netflix is expected to add more than 20 million new users this year, a significant increase from less than 9 million new additions last year, mainly due to cracking down on password sharing and introducing cheaper packages with ads.

The company stated that it has launched ad-supported versions in 12 markets, and in the third quarter, about 30% of new customers in these markets chose the ad-supported package, resulting in a nearly 70% QoQ increase in the number of members of this package.

As the only profitable mainstream streaming media platform globally, Netflix's first-mover advantage and dominant position are reflected in its pricing power. Sure enough, Netflix is raising prices again in the largest European and American markets.

The pricing of ad-supported packages in the US market will remain at $6.99 per month, but starting from Wednesday, the basic package will increase by $2 to a monthly subscription fee of $11.99, the premium package will increase by $3 to a monthly subscription fee of $22.99, and the standard package will remain unchanged at $15.49 per month. The UK and French markets will also raise prices simultaneously to improve profitability and cope with higher production costs.

Netflix's guidance for the fourth quarter is slightly below expectations, but the market is optimistic about its upward revision of the full-year profit margin and free cash flow expectations

However, Zerohedge, a financial blog known for its sharp tongue, found that although Netflix performed well in the third quarter, its guidance for the fourth quarter is relatively weak, with revenue, EPS, and profit margin all lower than Wall Street's consensus expectations.

Netflix expects fourth-quarter revenue to be $8.69 billion, an 11% YoY growth, while the market expects $8.76 billion; Netflix expects EPS to be $2.15, while the market estimates $2.17; Netflix expects an operating profit margin of 13.3%, while the market estimates 14%.

The company stated that it expects the number of net paid additions in the fourth quarter to be similar to the third quarter, and the average revenue per member (ARM) worldwide will remain roughly the same YoY, mainly due to limited price increases in the past 18 months. In addition, the strengthening of the US dollar against other currencies in the past few months will have a drag of approximately $2 on fourth-quarter revenue.

As for the full-year guidance for 2023, Netflix has raised its operating profit margin to 20%, which is at the upper limit of the previously expected range of 18% to 20% and slightly higher than analysts' expectations of 19.8%. The company has also raised its free cash flow guidance for the full year to $6.5 billion, higher than the previous estimate of $5 billion and significantly higher than the market's expectation of $5.27 billion. **Both of these points have been well received by investors. Netflix said that this year's free cash flow is expected to be much higher than last year's $1.6 billion, due to the Hollywood writers and actors strike reducing cash content spending in 2023 by about $1 billion. Cash content spending is expected to be around $13 billion this year:

"Assuming that the actors' union strike is resolved in the near future, we expect cash content spending in 2024 to peak at $17 billion. Despite the industry strike causing fluctuations in free cash flow, we still plan to achieve significant positive free cash flow next year. Assuming no significant exchange rate fluctuations, the operating profit margin for the fiscal year 2024 is expected to be between 22% and 23%."

In addition, Netflix's total debt at the end of the third quarter was $14 billion, within the company's target range. Cash and short-term investments amounted to $8 billion, with net debt of $6.5 billion. During the quarter, the company repurchased 6 million shares of stock for $2.5 billion. In September, the board of directors authorized an additional $10 billion in stock repurchases on top of the remaining $1 billion previously authorized.

Netflix "humbles" itself, revenue from ads still in the "crawling stage," but will enter the gaming and more content licensing markets

Analysts generally believe that as the world's largest media companies join the streaming media battle, Netflix is shifting from focusing on subscriber growth to maximizing revenue through price increases, introducing ad-supported subscription plans, and cracking down on account sharing.

Investors will be paying close attention to whether the company will provide details on the development of ad-supported plans, whether other subscription services will see further price increases, and whether the nearly 150-day-long writers' strike in Hollywood and the ongoing actors' strike have caused delays in content production.

Company executives have previously warned investors that their advertising business is still in its early stages and will not have a significant impact on revenue until at least the end of this year. They also stated that as they invest in more growth opportunities, future operating profit margins will grow more "moderately."

Last week, many analysts lowered their target prices and performance forecasts for Netflix, with most waiting for further clarity on the company's growth strategy. Some are concerned that the revenue growth brought by the advertising business has not been fully realized, which could threaten the company's goal of double-digit revenue growth.

The company's CFO mentioned the ad-supported plan last month, saying, "We are still in the crawling stage of going from crawling to walking to running. It is not easy to build an advertising business from scratch, and there is still a lot of work to be done." He also stated that the growth initiatives are starting to take effect, and with the company's entry into the gaming and more content licensing opportunities, profit margins are expected to "rise again" in the future.

Wall Street is concerned that investment plans will damage recent growth, and the increased content costs from the Hollywood strike will harm profit margins.

Analysts generally believe that many of Netflix's growth initiatives may not impact its profitability until next year.

Steve Cahall, an analyst at Wells Fargo, pointed out last week that Netflix's investments in advertising technology and original content creation and licensing will reduce profit margin expansion but also accelerate revenue growth. He maintains a buy rating because he is "optimistic about long-term growth."

However, Wolfe Research withdrew its $500 target price and "outperform" rating last week, mainly due to concerns that the growth challenges by 2025 will make it difficult to maintain a high premium relative to the S&P 500 index:

"Earlier this month, there were reports that Netflix plans to raise the price of its ad-free subscription package after the end of the Hollywood actors' strike. Combined with cracking down on password sharing and cautious comments recently made by the company's CFO, the two major driving factors of Netflix's mid-term P/E ratio, net user growth and operating profit margin, seem to be facing increasing risks."

Overall, Wall Street is mainly concerned about the short-term growth challenges facing Netflix. Any changes in the advertising subscription plan and other pricing strategies may suppress future growth. While introducing more licensed content from other platforms can enhance Netflix's content library, it may also become another threat to profit margin as content costs soar, especially in the wave of Hollywood writers and actors strikes.