Good morning,

It’s the NBA playoffs, so a basketball-related meme felt appropriate:

On to the update.

Netflix Earnings

From CNBC:

Netflix on Tuesday reported a loss of 200,000 subscribers during the first quarter — its first decline in paid users in more than a decade — and warned of deepening trouble ahead. The company’s shares cratered more than 25% in extended hours after the report on more than a full day’s worth of trading volume. Fellow streaming stocks Roku, Spotify and Disney also tumbled in the after-hours market after Netflix’s brutal update. Netflix is forecasting a global paid subscriber loss of 2 million for the second quarter. The last time Netflix lost subscribers was October 2011.

“Our revenue growth has slowed considerably,” the company wrote in a letter to shareholders Tuesday. “Streaming is winning over linear, as we predicted, and Netflix titles are very popular globally. However, our relatively high household penetration — when including the large number of households sharing accounts — combined with competition, is creating revenue growth headwinds.”

Netflix previously told shareholders it expected to add 2.5 million net subscribers during the first quarter. Analysts had predicted that number would be closer to 2.7 million. During the same period a year ago, Netflix added 3.98 million paid users.

On one hand, these earnings are bad (although it’s worth noting that Netflix would have grown by 500,000 subscribers had they not pulled out of Russia). On the other hand, I actually think they are worse than they appear!

First off, Netflix basically confirmed my thesis that COVID delayed an inevitable reckoning in terms of saturation and increased competition; CEO Reed Hastings said in the earnings interview:

I think our views are a little different because our numbers are a little different. If we had made our 2.5 million guidance, I think that was consistent with our thesis. And the lower acquisition really forced us to kind of tease apart what’s going on. And as we put in the letter, COVID created a lot of noise on how to read the situation, boosted us a lot in 2020. And then in 2021, I think we thoughtfully said it was mostly pull forward, which was the logical conclusion. But now, coming into 2022, that doesn’t really hold. So then pushing into it, we realized, with all of the account sharing, which we’ve always had, that’s not a new thing, but when you add that up together, we’re getting pretty high market penetration. And that, combined with the competition, is really what we think is driving the lower acquisition and lower growth.

Questions about account sharing and increased competition aren’t new; what is new is Netflix admitting they are factors. To that end, I appreciated the honesty in this letter and interview — Netflix executives made clear that they viewed the situation as a crisis akin to other major challenges in the company’s past — but it is very fair to be critical of the cavalier way in which Netflix dismissed these looming concerns previously.

With regards to shared accounts, Netflix said in its investor letter:

In addition to our 222m paying households, we estimate that Netflix is being shared with over 100m additional households, including over 30m in the UCAN region. Account sharing as a percentage of our paying membership hasn’t changed much over the years, but, coupled with the first factor, means it’s harder to grow membership in many markets – an issue that was obscured by our COVID growth.

This was Netflix’s big pitch as far as upside goes, arguing that revenue and average engagement per account would increase as Netflix started forcing multiple-household accounts to pay more; again from the investor letter:

This is a big opportunity as these households are already watching Netflix and enjoying our service. Sharing likely helped fuel our growth by getting more people using and enjoying Netflix. And we’ve always tried to make sharing within a member’s household easy, with features like profiles and multiple streams. While these have been very popular, they’ve created confusion about when and how Netflix can be shared with other households. So early last year we started testing different approaches to monetize sharing and, in March, introduced two new paid sharing features, where current members have the choice to pay for additional households, in three markets in Latin America. There’s a broad range of engagement when it comes to sharing households from high to occasional viewing. So while we won’t be able to monetize all of it right now, we believe it’s a large short- to mid-term opportunity. As we work to monetize sharing, growth in ARM, revenue and viewing will become more important indicators of our success than membership growth.

Netflix further clarified in the earnings call that their approach would not be to force add-on households to get their own accounts, but rather to charge the base account:

There is a group of viewers that are not paying us, and they’re sharing someone else’s account credential. And we really see that second group as a tremendous opportunity because they’re clearly well-qualified. They have everything they need to do to get to Netflix. They know what the service is. They found titles that they want to watch. And so now, our job is really to better translate that viewing and the value that those consumers are getting into revenue. And the principal way we’ve got of going after that is asking our members to pay a bit more to share the service with folks outside their home. So if you’ve got a sister, let’s say, that’s living in a different city, you want to share Netflix with her, that’s great. We’re not trying to shut down that sharing, but we’re going to ask you to pay a bit more to be able to share with her and so that she gets the benefit and the value of the service, but we also get the revenue associated with that viewing.

A few points on this:

• First, I expect Netflix to be pretty good at this; speaking from experience Netflix has always been much better at cutting off VPNs and proxy servers for people trying to change their geolocation than their competitors. Yes, the company will want to be careful to not punish frequent travelers (consultants who travel to the same city for weeks or months might have some trouble here), but I expect the company to find password sharers in short order.
• Second, one of the reasons I argued that Netflix Should Sell Ads (more on this in a moment, natch) was precisely to have a soft-landing for password-sharers: going from never paying for Netflix because you are using your parents’ account, to having to pay $15.49/month (for 2 streams and HD), is a big leap that an advertising tier could soften. Netflix seems to have had the same concerns, but a different solution: make the originating account pay more — if they want to cut off the password sharer, it’s their responsibility to break the bad news.
• Third, keep in mind that Netflix already has tiers: in the U.S. the highest tier is $19.99/month for four streams and 4K; one obvious reason to pay for that tier is if you are sharing your account (and thus need more streams). In other words, I think it is likely that Netflix’s financial upside is less than it first appears in part because some amount of its average revenue per user is already driven by password sharing.

These last two points bracket the financial upside, at least in the U.S. and Canada (UCAN):

• Two two-stream subscriptions are $30.98/month
• One four-stream subscription is $19.99/month
• An obvious price point for an out-of-home four-stream subscription is ~$25/month

That’s $5/month of incremental revenue; should Netflix convert 75% of the 30 million password-sharers in UCAN that would be around $1.35 billion in incremental annual revenue — a 12% boost to the company’s 2021 revenue. It’s a decent chunk of change, albeit less revenue growth than the 19% increase between 2021 and 2020. Moreover, it’s a source of growth than can only be tapped once (although it will take a while to fully capture).

Netflix’s Struggling Growth Drivers

More sustainable growth is found in Netflix’s usual drivers: increased subscribers, and increased prices. This is where these results were particularly concerning.

First, Netflix’s subscriber numbers decreased almost everywhere:

• The United States and Canada decreased by 600,000 subscribers
• Europe, Middle East, and Africa decreased by 300,000 subscribers (including the 700,000 subscribers lost in Russia)
• Latin America decreased 400,000 subscribers
• Asia Pacific increased by 1.1 million subscribers

This was a surprise to me; I’ve been writing about how Netflix had saturated UCAN for many quarters now, but I wasn’t expecting declines in multiple geographies.

Secondly, the primary driver of the miss in projections was churn. CFO Spencer Neumann said on the earnings interview:

We guided to 2.5 million paid net adds. We delivered 0.5 million, if you exclude Russia. So there’s really a 2 million miss in our Q1 actuals versus guidance. And what’s really reflected there is acquisition growth was consistent with what we expected. We were seeing that slowdown when we did the guide, and it played out as expected. The difference is really some slight elevated churn throughout Q1. And this is pretty small. So retention was still very good, but we’re talking about it like 0.2 to 0.3 percentage point, but on our big member base, that has a pretty big flow through.

The flow through impact isn’t simply a function of the size of the user base: it’s also a function of time. Churn is such a killer because you feel the missed revenue not just in the month it churns, but also the month after that, and the month after that; recurring revenue giveth, and it also taketh away!

What is particularly concerning, though, is that this churn increase happened the same quarter that Netflix implemented a price increase. Netflix executives went out of their way to argue that price-related churn was in-line with their expectations, but it is difficult to accept that argument given that those same executives just underestimated churn to the tune of 2 million net subscribers, and, more broadly, had to admit that all of their bravado on recent earnings interviews was mistaken.

This, by extension, casts doubt on Netflix’s long-term ability to raise prices. Yes, the most recent price raise was still revenue accretive — $2 on millions of subscribers quickly outweighs some amount of churn — but what made these earnings so concerning is that there are now serious questions about both of Netflix’s obvious growth drivers in a way that extends far beyond assumptions about UCAN saturation.

Netflix to Explore Advertising

Just to set the scene: Netflix always releases a shareholder letter and a pre-recorded earnings interview conducted by an analyst who I assume is selected by Netflix (as a side note, Netflix is moving to a more traditional share structure, getting rid of preferred shares and the like; I wish the company would also go back to a traditional earnings call). The shareholder letter said nothing about advertising; Hastings, though, deliberately went out of his way to bring it up on the earnings call, without being asked. Here is the exchange:

[Chief Product Officer Greg Peters gives an answer about pricing tiers]

Reed Hastings: And related…

Neumann: One thing, just — go ahead, Reed. Sorry.

Hastings: Related to that, Greg has done great work on the price spread. And one way to increase the price spread is advertising on low-end plans and to have lower prices with advertising. And those who have followed Netflix know that I’ve been against the complexity of advertising and a big fan of the simplicity of subscription. But as much I’m a fan of that, I’m a bigger fan of consumer choice. And allowing consumers who would like to have a lower price and are advertising-tolerant get what they want makes a lot of sense. So that’s something we’re looking at now. We’re trying to figure out over the next year or 2. But think of us as quite open to offering even lower prices with advertising as a consumer choice.

Hastings went on to make clear that Netflix was absolutely going in this direction:

I think it’s pretty clear that it’s working for Hulu. Disney is doing it. HBO did it. I don’t think we have a lot of doubt that it works, that all those companies have figured it out. I’m sure we’ll just get in and figure it out as opposed to test it and maybe do it or not do it. So I think we’ll really get in. But again, it would be a plan layer, like it is at Hulu. So if you still want the ad-free option, you’ll be able to have that as a consumer. And if you would rather pay a lower price and you’re ad-tolerant, we’re going to cater to you also.

What was surprising is that Hastings suggested that Netflix’s advertising would be programmatic:

The online ad market has advanced. And now, you don’t have to incorporate all the information about people that you used to. So we can be a straight publisher and have other people do all of the fancy ad-matching and integrate all the data about people. So we can stay out of that and really be focused on our members creating that great experience and then again, getting monetized in a first-class way by a range of different companies who offer that service.

Look, I obviously want to crow about this point given that I just argued that Netflix should sell advertising two weeks ago. My desire to toot my own horn, though, is tempered by a couple of things:

• First, like I said above, these earnings were quite a bit worse than I, a long-term Netflix bull who has also been predicting a difficult few years for the company, expected. That calls for a bit of humility.
• Second, the haphazard way that Hastings announced this initiative feels like this is a bit of a last minute decision that was thrown into the earnings interview in the desperate hope that it would arrest Netflix’s stock plunge.
• Third, the idea that Netflix would simply outsource ad sales is not only a mismatch with the Netflix brand, which still retains some vestiges of being premium (truckloads of filler content notwithstanding), but is also contrary to the way that the ad market is evolving in a post-App Tracking Transparency (ATT) world.

If Netflix is going to offer ads, the company ought to do it right: that means building up its own targeting and sales infrastructure that takes advantage of the information it has about its users, and which avoids the need to interact with 3rd parties, further avoiding the problems with ATT. Indeed, this route seems so clear to me that I wouldn’t be surprised that Netflix ends up here. That, though, only reinforces the idea that this was a very recent decision and a last minute throw-in to these earnings, and that, more than anything else, makes me feel like things are even worse than they appear. Netflix is a company that always feels in control, and that simply wasn’t the feeling I took away from the earnings interview.

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