In the highly dynamic and challenging realm of digital streaming, Netflix Inc. (NFLX, Financial) has not only gained its place as a leader, but has become an example of strategic resilience and far-sightedness. Following the steady rise in competition over the past decade, Netflix's growth from a DVD rental service to the mighty streaming giant it is today demonstrates how growth can be sustained through smart market maneuvering and employing data-driven strategies.
Historic growth amid rising competition
The digital media platform became a target of various modern market actors and the number of such companies offering these services has increased for the last five to 10 years. Despite this crowded space, Netflix has achieved a remarkable feat by gaining the economies of scale its competitors have long been working for and are still struggling to get.
This is illustrated by an August 2022 report from Nielsen that says 78% of American households are now customers of at least one streaming platform, which raised streaming services' share of total viewing time to 34.80%, exceeding cable for the first time in history. This revolutionary shift in consumption pattern, and the resentment of insufficient and costly cable packages, signals the golden age is at the doorstep of streaming giants like Netflix, whose premium content catalogue is provided at budget-friendly prices.
Recent performance
Netflix faced an unprecedented churn of subscribers in the first half in 2022, which was a tough period for the giant. Nevertheless, the last months of the year and the beginning of 2023 proved to be more favorable as it reasserted its dominance in the market and demonstrated impressive growth. The company's growth story is illustrated through its strategic move toward an ad-based business model to curtail the content piracy problem, among others. These actions not only stopped the decline, but have also pushed the stock up from the beginning of the year by over 80%.
The fourth quarter of 2023 was a standout one with revenue growth of 12.50% year over year, earnings per share rising to $2.11 from 12 cents and paid memberships increasing from 231 million to 260 million. Such a striking transformation is proof of the highly flexible mindset of the streaming giant, hence its aptitude to keep changing with market circumstances.
The streaming industry in the last 10 years has become the platform for a fierce contest between many existing and new players in the market. Nielsen's report indicates that in 2022, streaming overtook both cable television and broadcast television for the first time in history. Streaming now accounts for a share of total viewing time of 34.80%, which is also more than cable television that has 34.40% and broadcast television that encompasses 21.60%. This indicates the move away from pricey cable TV will continue. At present, as per Fortune Business Insights, the industry is now estimated to be worth $671.89 billion, up from $544 billion in 2023. As reported by Statista, forecasted sales volume will reach $43.97 billion by 2024, which should further climb up to $54.22 billion in 2027, growing an average of 7.53% annually if we keep in mind the previous year increases.
Having said that, nobody else has been able to attain the same economies of scale that watching Netflix has achieved. Its strategic position remains unbeaten as the undisputed streaming service leader, with a phenomenal 260.28 million subscribers around the world, which is 24% greater than that of its closest, rival, Amazon (AMZN, Financial) Prime.
Share price history and Netflix's strategy shifts
During the first two quarters of 2022, Netflix suffered a net loss of 1.20 million subscribers, which went against expectations. This was followed by a drop in the stock, where prices declined nearly by 76% from an all-time high. As a result, the attention turned to around 100 million users having access to Netflix without paying. The first-quarter 2022 letter to shareholders highlighted the outstanding revenue potential of converting these 100 million password-sharing households into paying customers. This ultimately became one of the key reasons the company was able to bring its business back on track.
Following up on this strategy, over the past 12 months, the company has been putting restrictions on password sharing in most countries, with an option for subscribers to add additional users for an extra cost. The objective of this strategy is to convert about 70% of "password pirates" over three years into paying subscribers, with the subscribers divided between the two types (full and reduced fee add-ons).
The strategy, which many thought would make Netflix lose a number of its subscriber base, turned out to be a masterstroke. As per the data from Antenna since May 2023, when Netflix informed subscribers in the United States that it was going to start to limit password sharing, the streaming service has had four of the biggest days of subscriber acquisition in the four and a half-year measurement period that it has been tracking the service. Netflix reported a record-breaking 100,000 sign-ups each day on both May 26 and May 27.
Another unexpected strategy was the introduction of an ad-supported subscription tier, something which Netflix had held off for a long time, although a number of competitors already had such plans available. The decision was made in order to have more choices for cost-driven viewers, particularly in the face of increasing subscription prices. This surprisingly lower-priced, ad-supported plan saw a 70% membership increase in the fourth quarter of 2023.
The advertisement-supported plans are strategically created to minimize churn, grow member's pool and consequently drive ARPMs, thereby increasing overall revenue. In the U.K. and U.S., for new users the ad-supported service has replaced the basic plan and is available at a 30% cheaper price of $6.99 per month instead of the ad-free $9.99 plan. In spite of a general trend of higher churn rates among other players of the industry (from 4.70% in July 2022 to 6% in July 2023), Netflix recorded a slight drop in churn rates (as reported by Antenna).
The ad plans are cutting the churn by luring in users who might otherwise go elsewhere because this service substitute is too expensive for them. Since the affordability crisis is still prevailing out there, it makes sense to some of the users dropping from the $15.49 plan to the $6.99 plan to cut back on spending without giving up the platform entirely. On the other hand, this approach also targets people who previously hesitated to subscribe to the higher-priced plan, but are now more likely to do so due to the drop in monthly payments. As illustrated above, by May 2023, the ad-supported plans that had been around for six months had already gained around 5 million active subscribers. Interestingly, more than 40% of the newly-joined subscribers preferred this tier, which saw a quarter-over-quarter growth of 70% in the fourth quarter and followed by the same growth rate in the preceding quarter.
Further, I believe that during the next five to 10 years, ad revenue will account for a considerable growth driver of Netflix's revenue, given the accelerating shift from linear networks to streaming platforms. Streaming networks do personalized advertising based on demographic data and viewing behavior, just like social networks, resulting in higher return on investment for ads that are just seen by their intended audience. It is this accuracy that propels the performance of industry leaders such as Meta (META, Financial), Alphabet's (GOOG, Financial) Google and Amazon, which alone raked in over $400 billion in earnings from ad revenue in 2022. With the decrease in appeal of traditional television, Netflix is now in a position of striking the jackpot with this highly lucrative opportunity.
Financial resilience
The financial performance of Netflix appears to be bright nearly across all metrics. The fourth quarter exhibited growth in year-over-year revenue from 1.90% in 2022 to 12.50% in 2023. Earnings per share increased from 12 cents to $2.11, while the number of paid memberships rose from 231 million to 260 million. Quarterly free cash flow jumped from $332 million to nearly $1.60 billion.
Additionally, Netflix executed a strategic share repurchase program that led to a reduction in its diluted share count from around 451.60 million to 444.30 million. While the competitors are fighting for their profitability, the company has upped its operating margin by 280 basis points to 20.60% (2023) and is projected to increase to 24%, highlighting its growing scale advantages. For 2024, $6 billion in free cash flow is expected. After a stock buyback of $6.10 billion last year, more buybacks seem imminent. While it may look overpriced with a price-earnigns ratio of 47.10, which falls to 33.20 on a forward basis, the progressive double-digit growth rates of revenue, earnings and FCF are enough to justify Netflix's valuation.
Content expenditure grew from $1.75 billion in 2012 to $16.70 billion in 2022, mirroring the growth rate of revenue (increased from $3.60 billion to $31.60 billion). However, Chief Financial Officer Spencer Neumann pointed out the company's most cash-intensive phase of developing original programming is near an end, expecting a slower rate of content cost growth for the upcoming period. This sizable budget still provides for many more content additions to the already staggering content library. Simultaneously, the operating expenditure costs as a part of revenue were down from approximately 25% to 21% over the last five years, which I am expecting to continue as free cash flow increases, reducing borrowing needs and interest expenses. The company also intends to continue the practice of share repurchases and thus, reduce the number of issued shares. Fall in content spending and expenses will mean that robust double-digit revenue growth will be mirrored in business profits and earnings per share since every new dollar of revenue contributes directly to the net profit.
Takeaway
I believe based on the fact the net margin is expected to reach 24% in 2024 and free cash flow is estimated to be $6 billion, among other things discussed above, Netflix's future looks promising. The emphasis made by management on disciplined growth in operating expenses and content costs implies the net income will be maintained to buy investments which have more ROI or to decrease debt or return value to the shareholders by means of buybacks.
The advanced business development places Netflix years ahead of its competitors, which are still struggling to be profitable. Yet potential for further growth remains high, which the company is achieving by diversifying with additions to the gaming range through "Grand Theft Auto" and the further licensing of content from legacy media partners, strategic partnerships like WWE, the "Stranger Things" play in London, launching a Bridgerton-themed wedding dress collection, the Queen's Ball and "Squid Game" live experience.
All of these factors put Netflix in a league of its own. Some of the concerns one has to look at when investing in Netflix are the stock is fairly valued with a forward price-earnings ratio of about 33, which is relatively higher. Many broad macroeconomic factors could be threats, particularly for a company that depends on greater consumer expenditure. Also, Netflix's revenue growth rate might slow down in the future, especially when the effect of the password-sharing ban and the launch of new ad-based subscription plans becomes less impactful.
Having said that, I anticipate the pros outweigh the cons. Further, I foresee Netflix taking more innovative risks, driving further consistent growth, reinforcing my recommendation of being an appealing opportunity at this point.
