Good morning,
Happy Lunar New Year! The annual week long holiday begins today in Taiwan; Saturday is the first day of the Year of the Rat. 恭喜發財！
On to the update:
Netflix Earnings
From the Wall Street Journal:
Netflix Inc. missed its forecast for U.S. subscriber growth for the third straight quarter, but blew through its expectations for overseas expansion, a mixed performance that comes as the streaming giant faces heightened competition from a gaggle of rivals.
The Los Gatos, Calif., company said Tuesday that it added 423,000 domestic subscribers in the fourth quarter, compared with its forecast of 600,000 additions. It also posted an increase of 8.3 million subscribers in overseas markets, more than the seven million the company was expecting. It now has 167 million subscribers world-wide, including 60.4 million in the U.S. Shares in Netflix were up 2.3% in after-hours trading on Tuesday.
Shares ended up dropping 3.58% on Wednesday, perhaps because of Netflix’s conservative subscriber forecast, particularly relative to last year (which had record Q1 growth). Still, those forecasts continue to be unreliable in both directions and, as the Wall Street Journal article notes, missing U.S. subscriber numbers by 0.177 million is outweighed by beating international subscriber numbers by 1.3 million.
There were a couple of items worth noting in the company’s financial results as well. On the negative side, marketing as a percentage of revenue was 16%, which is the second highest mark ever, trailing only Q4 2018’s 17%. Worse, that spend resulted in fewer net new subscribers (8.76 million) than Q4 2018 (8.84 million).
I did a much deeper dive into Netflix’s marketing spend in 2018, where I argued that the company’s reported marketing costs provided an incomplete view into Netflix’s customer acquisition costs:
That means, though, that an accurate measure of Netflix’s customer acquisition costs should include the cost of content, at least in part. For a rough approximation you could use the company’s negative free cash flow as a proxy for which content costs should be attributed to customer acquisition (because the company is using debt to invest in content under the presumption that it will attract future subscribers that will pay for it); presuming 20% churn, it turns out Netflix’s real customer acquisition costs are much higher than what they seem.
Here is the chart that followed, updated through this last quarter:
Marketing definitely continues to trend higher — note that Q2 was even worse from a CAC perspective — but still, the company’s spend-ahead on content, presuming you agree with my reasoning as to why it should count in customer acquisition costs, remains the biggest driver, and it skyrocketed again.
Speaking of that negative cash flow, the final total was -$3.27 billion for the year, up from -$3.02 billion in 2018. The difference is worth noting because of what Netflix said after earnings a year ago:
Free cash flow in Q4’18 was -$1.3 billion vs. -$0.5 billion in Q4’17, totalling -$3 billion for 2018 (compared to our original forecasted range of -$3 to -$4 billion for the full year). We expect 2019 FCF will be similar to 2018 and then will improve each year thereafter (assuming, as we do, no material transactions). This FCF improvement will be driven by growing operating margin, which will allow us to fund more of our investment needs internally.
The fact that Netflix ended up having 7% more negative cash flow in 2019 does suggest that growth overall was a bit more sluggish than the company expected, likely because of more elasticity of demand than expected. That noted, Netflix reiterated in their investor letter this quarter that this quarter would be peak negative cash flow, and the company’s improving gross margins (37% versus 35% a year ago) suggest that the company is still gaining scale on its costs. Of course given the way Netflix amortizes content costs, profits are very much a trailing indicator, albeit one with a story to tell.
Self-Production, Cash Flow, and Margin
Here is Netflix’s gross profit margin over the last five years:
There was a meaningful shift two years ago; interestingly, that shift aligned with a big increase in Netflix’s negative cash flows:
At first glance, these graphs seem to be contradicting each other: Netflix was spending more money even as its margins were increasing?
The answer to this riddle was provided by Spencer Neumann, Netflix’s Chief Financial Officer, on Tuesday’s earnings interview. The question was what was most misunderstood about the company:
I think what was most misunderstood is the business model and what you see in our cash flow generally, and folks thinking that we are losing money. What we’ve shown is that we are increasing our profitability both through growth and growing our profit margins. And what you’ve seen over the last few years is forward investment as we’ve been going through a really kind of pretty significant transition of our business model from licensed content, where you pay basically ratably for content you receive over the time, and it’s on the network, to original content, not just licensed originals, but self-produced originals where oftentimes we’re investing many years before that content is on the service.
And we’ve moved, as they say, well, along the curve there were the bulk of our cash spend is now on original content. So as we’ve gotten bigger, as we’ve moved towards originals, it just fundamentally changes that cash flow profile over time. And we’re a very profitable business and one that will ultimately over the years become meaningfully self-funding.
I wrote about the significance of Netflix shifting to self-production back in 2016, but primarily in terms of how that was the natural endpoint for a service built on Internet assumptions:
Netflix’s shift here is important: owning content means it will only ever be available on Netflix forever (unless Netflix itself licenses it, as they plan to do in China). This was never a viable business model before the Internet: content creation is a massive fixed cost that is best paid for by getting it in front of the maximum number of customers; this meant maximizing reach both geographically (worldwide licensing agreements) as well as temporally (exclusive licenses for first-run, then syndication for re-runs). This meant that the optimal approach was for one set of companies to invest in content creation and then make deals with a completely different set of companies which managed distribution in different geographic regions and on different time scales.
Netflix is completely different: the service is fully global, which takes care of geographic reach, and is fully on-demand, which means shows are available from the moment they are released until the end of time (or Netflix). I know this sounds obvious but this is really a dramatic change: the Internet has effectively allowed Netflix to replace every single video distributor on earth with a single entity, which by extension makes it possible to integrate backwards into the actual creation of content. Of course this is very expensive, but that is where Aggregation Theory comes in: by winning on the user experience Netflix has accumulated significant enough subscription revenue that the company can afford to modularize content creators to the show level (augmented by debt, which effectively pulls forward revenue from anticipated future growth).
Earlier in that Daily Update I did note that “owning a show (as opposed to licensing it) is much more expensive up-front”, but I failed to fully internalize the implications: the more that Netflix’s content spend shifted to self-production from licensing, the more front-loaded its content costs would be. It follows, then, that cash outflows would increase substantially but profit margins would increase as those cash outflows were amortized (since Netflix was cutting out the middle-person). That’s exactly what has happened!
Netflix’s New Rung
I first coined the term “ladder-up” strategy in the context of Netflix when they went global in 2016:
Netflix remains the textbook example of what I would call a “ladder-up” strategy:
- Netflix started by using content that was freely available (DVDs) to offer a benefit — no due dates and a massive selection — that was orthogonal to the established incumbent (Blockbuster). This built up Netflix’s user base, brand recognition, and pocketbook
- Netflix then leveraged their user base and pocketbook to acquire streaming rights in the service of a model that was, again, orthogonal to incumbents (linear television networks). This expanded Netflix’s user base, transformed their brand, and continued to increase their buying power
- With an increasingly high-profile brand, large user base, and ever deeper pockets, Netflix moved into original programming that was orthogonal to traditional programming buyers: creators had full control and a guarantee that they could create entire seasons at a time, and, in the beginning, the rights to use what they created elsewhere (more on this is a moment)
Each of these intermediary steps was a necessary prerequisite to everything that followed, culminating in yesterday’s announcement: Netflix can credibly offer a service worth paying for in any country on Earth, thanks to all of the IP it itself owns. This is how a company accomplishes what, at the beginning, may seem impossible: a series of steps from here to there that build on each other. Moreover, it is not only an impressive accomplishment, it is also a powerful moat; whoever wishes to compete has to follow the same time-consuming process.
Netflix’s shift to fully self-produced content points to another rung on the ladder: the fact that the Netflix brand matters more than any one particular show. This was Chief Content Officer Ted Sarandos’ answer to the “misunderstood” question:
In terms of misunderstood, I think there is this notion you hear every once in a while to where there is so much stuff on Netflix everything gets lost. And I think that the opposite is true, which you’ll see in those numbers that we release you in the letter. Our ability to launch new brands, to sustain brands over multiple seasons or multiple sequels, and at a very high volume from all over the world has been unparalleled. And the idea that we can create brands out of thin air over and over again sometimes multiple times in a week like this past week is something that I’m super proud of. And I think it gets lost on people because they think all this content is for them. It isn’t. It’s just meant to be your favorite show and your favorites movie and that’s going to be something for everybody.
See also CEO Reed Hastings answer about Netflix losing Friends:
It was about years 10 ago we had to drop all the Disney content, not phased out like we are now, but all at once, that we had in the Starz deal. And we were all worried about the big impact and instead people came back. The magic of the personalized service was they were able to find other things to watch and viewing growth just kept rising.
Sarandos added:
We’ve seen that phenomenon over and over again, even one that may be been even more dramatic than that was when all the Nickelodeon content came off and was completely displaced by other kids watching overnight. I should say equally good content — just people had the ability to find something new.
People do not come to Netflix because of a show; they watch a show because it is on Netflix. That is why Netflix’s viewing numbers continued to increase in a quarter where Disney+ and Apple TV+ dominated the headlines, and it’s why Netflix is ok puttering along with its strategy of releasing entire seasons at once, instead of an episode a week. Note this comment from Sarandos (emphasis mine):
It’s so unique. Sometimes the show can enter the zeitgeist in such a loud way like Stranger Things Season 3 around the 4th of July phenomenon, everything that happened that a lot of that viewing pops. Something similar we saw with a huge launch for Witcher: Witcher was kind of pent-up demand for known IP, but the show delivered for people, who delivered viewing hours for us. And people loved it right out of the gate. Other shows come out and they pop and they’re dependable and they build and people are going to watch it as soon as they finish what they’re watching right now. So it’s very different from show to show. I see you can see that in that list of how those shows will perform. And sometimes that it’s a really great indicator of its full-year performance. And sometimes its new shows will continue to build on their positive word-of-mouth and become even bigger over time.
Netflix is willing to forego the culture drumbeat enjoyed by, say, The Mandalorian, because (1) the goal is not first-run ratings and (2) it operates under the assumption that everyone already has Netflix, which means the viewers that care will get to it eventually. It also explains one other interesting tidbit from the call: Netflix executives claimed that they don’t have a set schedule for price raises, but rather wait and see how many hits they have.
Chief Product Officer Greg Peters: We don’t have a fixed model for our price raises…I think our job is to actually listen to our members. If the signals that they’re giving us in terms of the engagement that we’re seeing that we gain from growth that you heard we’re going after. And we’ll really use that as a mechanism to guide us towards whether we earned that opportunity to come back and ask for more. So we’re not really coming in with just a fixed model that we’re going to shift to or anything like that.
Chief Financial Officer Spencer Neumann: And if we’re putting hits on the board. We can see that in the terms of watching an engagement and subscriber growth and growth and the zeitgeist. The more you can do that the more frequently you can go back. So we have this great model of where we have to prove ourselves to our members literally every month.So it really does hold us to a very high bar and keeps us coming back and doing more and topping ourselves if we need to.
Here’s the thing with hits: per the previous point, existing customers are not going to watch them right away. They will add them to their queue — in the app or in their head — and that queue will be a reason to overlook a price increase. After all, you have a show you wanted to watch. And, by the time you watched it, you forgot about the price increase anyways. Oh, and by the way, Netflix already paid for the hit: that negative cash flow is not just customer acquisition costs, it is retention as well, and the margins are looking good.
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