Netflix Inc (NFLX) — Q3 2022 Earnings Call Transcript

Good afternoon and welcome to the Netflix Q3 2022 Earnings Interview. I'm Spencer Wang, VP of Finance, IR and Corporate Development. Joining me today are Co-CEO Reed Hastings; Co-CEO and Chief Content Officer Ted Sarandos; COO and Chief Product Officer Greg Peters; and CFO Spence Neumann. Our interviewer this quarter is Doug Anmuth from JPMorgan. As a reminder, we will be making forward-looking statements and actual results may vary. With that, let's jump into it. Doug, over to you for your first question.

Great. Thanks, Spencer. And great to see all of you and thanks for having me join you again today. So let's jump in with advertising. Obviously, a lot of discussion here heading into the launch. You announced details for the new basic with ads tier last week launching in the US and 11 other markets. Can you help us understand how you arrived at the price point and the product features for basic with ads?

Yes, Doug. So a lot of what we're thinking in terms of setting pricing for basic with ads and how we think about pricing in general anchors on what's the value that we're delivering to consumers. We're trying to work very hard to translate the dollars that they give us into incredible shows. And you can see some great examples of the series that we're delivering in Q3, the films we’re offering there, and their Q4 slate looks incredible as well. Specifically regarding ads, we modeled out what we think the expected revenue is in a variety of different countries that we're launching in to make sure that in a combination of the subscription price we’re charging for basic with ads, plus that anticipated monetization, we'd be roughly revenue positive to neutral. We believe that this lower consumer-facing price will bring in a lot more members; therefore, we’re quite confident that it will lead to a significant incremental revenue and profit stream in the long term.

Okay. And, I guess, just to clarify there when you talk about kind of getting neutral and perhaps more accretive over time, how -- what are you comparing that to on a unit economic basis that's essentially more to the basic tier?

Yes. It may be relevant to note that we don't see a lot of member switching plans. Oftentimes, when they come in and select a plan with a given feature, such as 4K resolution, that choice tends to be pretty sticky. When we're thinking about unit economics being neutral to positive, we're really comparing to the like feature set in the basic without ads.

Okay. Great. So maybe you could talk a little bit about what gives you confidence in that advertising arm? And how would you frame advertiser demand thus far? I know Jeremy, last week talked about having hundreds of advertisers on board and ad inventory almost sold out.

Yes. We started with several models that were informed by the ad activities in those different countries around the world. Now we're in the point where we get to take those models and bring them to advertisers to see what's working in practice. It has been great to see our partner Microsoft and their sales team as well as our small but effective ad sales team engaging with brands and agencies. The initial demand that we're seeing is incredibly strong. Advertisers are enthusiastic about bringing their brands and ads to a global audience watching our shows. The strong demand we’re observing is validating many of the expectations we built into our models. It's also worth noting that we are very much in a crawl-walk-run model, iteratively improving, and building additional capabilities over the next couple of quarters to make our advertising offering increasingly attractive.

Okay. So in terms of those capabilities targeting, obviously, very important here as well. I think you've talked about having broad targeting by country and genre and within the top 10 shows. I believe you also asked for age and gender at the time of sign-up as well. Early feedback from marketers and agencies has been that the targeting options at launch are fairly limited. What's your view on that? And how will that targeting evolve over time?

Yes. Part of what we want to do is actually get this out to market quickly. We went from announcing it to delivering it in about six months; this is a testament to a lot of hard work by our internal teams and Microsoft. We do have relatively basic targeting capabilities in terms of contextual targeting by genre, etc. But that's consistent with what we see with television as well. Our goal is to transition from that into more advanced digital targeting capabilities where we have a completely signed-in audience that's fully addressable and targetable. We want to ensure that privacy remains paramount and that data we use will only be used to deliver more relevant ads without building profiles outside of Netflix.

There's been a lot of discussion in the press about CPMs that are really 2x to 3x those of CTV or other AVOD players. Is that accurate? And what justifies the much higher pricing for Netflix?

I'm not going to comment on any specific pricing, but I would say that we have a very attractive offering. This is attributable to our unique audience, which is often difficult to reach in traditional TV. This is also a result of the incredible content that we have, which drives demand and allows us to command premium pricing.

Okay. You've talked about wanting the ad offering to be innovative and somewhat different over time. If we think about the range of four minutes to five minutes of ads per hour, it's certainly lower. You've talked about tight frequency capping. What else do you think is innovative at least in the initial offering? And then how does that evolve more over time?

Yes. As you noted, we want to start with an experience that's very pro-consumer-centric, which informs both our ad load and frequency capping. Interestingly, there is alignment between what advertisers desire and what we believe is beneficial for consumers. They are enthusiastic about not having high frequency caps and having a unique offering, as well as limited ad loads which sets their ads apart. Looking ahead, we're excited to leverage our capabilities over the next few years to drive innovation in the advertising space. Personalization is a key example where we can present ads uniquely across our member base, enhancing their experience.

And Doug, I might just add that part of the innovation was our ability to achieve speed to market. As Greg mentioned, we went from announcement to launch in just six months across all 12 markets, which represent a significant portion of our revenue today. This nimbleness and speed will support our innovation path going forward.

Okay. In terms of subscribers, how do you think about the concept of new net adds versus trade-down from existing subs on the basic with ads tier? This is obviously a frequent discussion with investors.

Yeah. It’s important to reiterate that we don't see a lot of plan switching among our existing members. We’re not trying to steer our members in any particular direction. We're focused on a consumer-first approach, allowing them to select the plan that best suits their needs. We've modeled out expected performance on ad monetization, which we considered in our pricing strategies for the basic with ads plan. We anticipate that this consumer-focused model will bring in a larger member base, given the attractive pricing. Even if some of those consumers switch plans, the overall economics and revenue should remain robust due to the influx of new members. This is expected to lead to a significant and incremental revenue and profit stream.

And how do you think about the impact in terms of reducing churn and perhaps how that plays out across some of the different markets given different characteristics and levels of penetration?

Generally, we’ve seen that offering a lower price point helps with churn. This is promising, but we are still in the early days and need to analyze the impact as we launch.

Again, so much of that is tied to engagement. The best way to reduce churn is to keep members entertained.

Right, which you've clearly done in this past quarter and we'll talk more about that in a minute Ted. At the Code Conference last month, Sundar said that the Netflix-Microsoft ad deal is one of the biggest ad deals ever. Are there particular components of the deal that give you confidence in the advertising revenue outlook here and how it compares to subscription over time?

One of the factors in selecting Microsoft as our partner was that we felt strategically aligned. They pursue a similar approach: launch quickly, learn rapidly, and iterate effectively. This flexibility applies to innovation around formats and approaches. There's an opportunity to leverage the combined market capabilities of Microsoft and our potential growth. With this demand, we're currently stretched between the two teams supporting all of it. I'm excited about growing our capacity on Microsoft's side, as they are likely to expand their team, as are we, enhancing our ability to serve advertisers better.

And Doug, at that same conference Bob Iger said that linear TV was going off a cliff.

He did.

What I underappreciated was just the impact on advertisers. They are now able to reach fewer people, and the 18 to 49 demographic is declining faster than pay-TV. This collapse of linear TV as an advertising vehicle is really fueling the cycle, aside from a few properties like sports.

So Reed, maybe that just brings up the question -- and for you as well, Greg. I mean when you're going out to agencies and marketers, do you feel like you're going after linear TV dollars or are you going after digital dollars right now?

I'd say when you look at the capabilities of our current offering as a publisher, we're mostly competitive with linear right now. However, we will integrate more digital attractive elements as we evolve. In terms of marketing dynamics, we are likely to lean into the brand side, where we can compete, while understanding that those lines will blur over time. Our goal is to remain competitive with the technical components we can add, such as targeting, and to leverage our incredible content and audience that advertisers want to connect with.

Okay. And Spence, in terms of ad revenue, it feels like it should be very high margin. Maybe you can just talk about some of the key costs or investments in running the ad business given that Microsoft is responsible for the bulk of that sales for now?

Yes, I'd agree with that, Doug. We need to build this out over time. As Greg mentioned, we feel good that on a unit economic basis, this will be net neutral to positive out of the gate. And considering the incrementality on subscribers, we believe we can build a significant incremental revenue and profit stream. There are costs related to our partnership with Microsoft, costs associated with building out our internal team, and some miscellaneous costs. Overall, we anticipate this will be margin accretive over time, though it will be relatively small at the beginning, which is reflected in our Q4 guidance. We don't expect any major financial impact in this initial quarter but will scale over time.

Okay. Great. All right. So, for the record, we're not hitting subscriber numbers until about 15 minutes in here. So -- but you added 2.4 million subs in the third quarter, expecting 4.5 million in Q4. Maybe you can just kind of walk us through how you're feeling about core subscriber growth before you get into the dynamics in 2023 around advertising and paid sharing.

Well, thank God, we're done with shrinking quarters. So that's a big feeling of positivity as we're back to growth. Obviously, this quarter and the guidance for Q4 are reasonable, not fantastic, but reasonable. We aim to pick up momentum. Everything the company is focused on, whether that's on the content side, marketing, lowering prices to the ad-supported tier, paid sharing, and other initiatives, align us for a strong next year. We still have FX issues, which are a significant challenge, but all other factors are aligning well for us.

Yes, Reed. You're doing my job for me, which is great. But yes, we're still growing, albeit not as fast as we'd like. We're building momentum and are pleased with our progress, but there's still much work to do. We're happy with Q3’s performance, having seen acquisition growth surpass previous quarters. Churn has remained slightly elevated, similar to the end of Q2. Still, combining these two factors, we delivered 2.4 million paid net adds, which was above our guidance. We're guiding for 4.5 million paid net adds in Q4.

Okay. Great. You had your two biggest English language series ever, I believe, in the span of three to four months with Stranger Things 4 and Dahmer. Do you believe the content cadence is becoming more normalized as you move past the pandemic? And how much of a factor were those titles in driving 3Q subs and the momentum into the fourth quarter?

Look, big shows that engage people drive a lot of growth. I do think that people come to value that. Our goal is to ensure that they expect excellent content regularly. After finishing something great, they anticipate that something new will follow. After Stranger Things Season 4, we rolled right into a substantial movie like Gray Man, or a film that moves you like Purple Hearts. We rolled right into Monster, the Jeffrey Dahmer story, and then into The Watcher. I believe we are improving in our ability to maintain a consistent content cadence as we mature in creating original content.

Yes. The other thing is -- go ahead, Reed, sorry.

Ted, maybe just discuss the smoothing of content monthly, kind of where we are this year and what you think we can achieve next year as we ease out of the COVID concentration.

Yes. COVID caused much of our content release to be concentrated later in the year, and it impacts continue to release as we return to normal. It will take several years to fully unwind the COVID backlog. Q4 will naturally have heavier releases compared to Q1 and Q2 due to the fall TV series and film cycles. We aim to improve our content smoothing to ensure availability when our audience is ready to watch.

And just to add to that, it's really about smoothing it across all content categories. We want there to be something great to watch for every mood or taste. In this last quarter, we've also seen big local titles with significant regional impact that can travel well, enhancing our overall content offering.

None exemplifies this better than Extraordinary Attorney Woo from Korea, which has watched 400 million hours globally. It shows that we can take locally produced shows and make them successful worldwide.

Okay. Ted, there's a lot of discussion around the philosophy around content. Is there a process or selectivity changing at all in terms of greenlighting content? Does it need to?

We started this about 10 years ago. We moved quickly to build our library, and over that period, we now have more viewing, revenue, and profit than our competitors who have been at this for over 100 years. While we've made many mistakes along the way, we have developed stronger skills, partnerships, and processes to ensure the quality of our content. This evolution enables us to engage audiences across every genre, ensuring our content reflects a broad range of tastes.

Okay. Great. You talked last quarter about content spending remaining around $17 billion. That's up this year when you take out incremental COVID costs from last year. Does the discipline around content spending push you to do anything differently? And what's your confidence in delivering quality content within that number?

We observe improvements in both the scope and scale of our content as well as our ability to release impactful hits. I feel confident about the $17 billion content spend as we aim to maximize impact per billion spent compared to competitors. Our focus is on providing value to our members, and we remain disciplined in our spending.

The Knives Out sequel Glass Onion is highly anticipated. You're releasing it in a limited number of theaters for a week around Thanksgiving before it hits Netflix. Can you talk about the rationale behind this decision?

We are focused on entertaining our members through Netflix. Our films receive significant attention in festivals due to their high demand from renowned filmmakers. The one-week release creates access to the film for audiences not near festivals while building anticipation ahead of its Netflix release. This model serves to create buzz and excitement around the film.

Got it. Let’s shift gears a bit and talk about paid sharing. You announced profile transfer yesterday, facilitating non-paying members shifting their recommendations and history to a new account. Can you discuss what this means for borrowers potentially becoming paying accounts?

Sure. The profile transfer supports several use cases, such as enabling your child to create their own account upon becoming an adult. It aids in refining our approach to paid sharing, allowing for a balance between customer choice and ensuring we’re compensated for the entertainment value we provide. This customer-centric approach guides our product changes. As we roll out these modifications, customer feedback remains crucial in our decision-making process to deliver what resonates with users.

Do you expect that the extra membership and new accounts could exceed advertising revenue for Netflix in 2023?

I wouldn’t define one as better than the other. They complement each other. We see various needs, whether it's an existing user wanting to share Netflix with someone else or a lower-priced plan accommodating new subscribers that balance monetization from ads. We view this range of options as an opportunity to cater to differing consumer needs with the right pricing and features.

Spence, could you discuss the decision to stop providing subscriber guidance starting next quarter?

Certainly. Initially, focusing on subscriber numbers was helpful, but now we have a wide range of price points and different partnerships globally. The economic impact of any given subscriber can vary significantly. This holds true especially when comparing our business against other streaming services. We have shifted to focusing more on revenue as our primary topline metric. This will be important as we introduce new revenue streams such as advertising and paid sharing, where membership growth is only one aspect of the revenue picture. We will continue to report our global and regional membership figures, providing guidance on underlying revenue drivers but not on specific paid net adds. We will still guide on other metrics such as revenue, operating income, operating margin, net income, EPS, and share count.

Okay. That’s helpful. If we look at the Q4 guide, the operating margin is impacted by FX pressures. It's 10% ex-FX and up from 8% year-over-year. Can you discuss the factors impacting this? Is anything fundamental weighing on 4Q margins?

It’s primarily due to FX, Doug, as you mentioned. Year-over-year, on a constant currency basis, we're on track for a 10% margin versus 8% from the prior Q4. The FX drag is significant, particularly felt in Q4 as we’ve built up throughout the year.

Can you talk about cash content spending and confirm that you're reiterating guidance around the $17 billion level going forward? What does that mean for cash flow generation in the next few years?

Yes, we're reiterating that guidance of around $17 billion is appropriate based on our current revenue trajectory. As Ted stated, as we expect revenue to reaccelerate, we'll revisit that number. For now, we believe we can provide increasing member value per dollar spent on content. We expect free cash flow for this year to be roughly $1 billion but predict significant improvement next year.

Doug, we have time for about two last questions, please.

Reed, according to Nielsen, streaming time currently surpasses both broadcast and cable, with Netflix playing a major role in driving that transition. What does this next period of streaming look like to you, considering the growing competition and increasing ad support?

That's a great question, Doug. Clearly, us and Disney are investing heavily and will be two key brands within the premium space. YouTube remains a force on connected TVs and will continue to grow. Depending on how the Sunday Ticket arrangement lands, you may see various parties focusing on sports and moving it to on-demand platforms. The transition resembles how mobile telephony replaced fixed-line telephony. Streaming will continue to grow each year, making TV more convenient and enjoyable. Smart TVs are now cheaper than most mobile phones, making them more accessible. This positive trend will allow us to fight for the best content, pricing, and user experience. We're excited about this next phase of competitive excellence as it drives us to improve execution.

Okay. To close out, I won’t ask about Q4 content. But I'd like to hear each of your key accomplishments for the next 12 to 24 months in your respective roles. You can choose the order.

For me, it's about ensuring everyone's clear on our overall direction. If we effectively follow this path, we will succeed. That excites me, and we’re on target.

Doug, we must continue delivering quality at scale. We’re not merely dumping content into the world; we're striving to serve hundreds of millions of viewers with tailored content interactions. Achieving this at scale is unprecedented, and it’s crucial to sharpen our tools for continued improvements. This time is pivotal, and we want to excel.

For me, I have two priorities. One is supporting our goal to create a large but profitable business while refining our approach to profit generation. Secondly, we've increased M&A activity over the past year, so it's crucial we improve integration processes to meet expectations.

I align with Spencer's perspective; we aim to improve financial discipline across the firm while supporting creative excellence. We're striving to increase the efficiency of how we spend towards delivering better content experiences for users worldwide.

Doug, I will also provide two points. Tactically, we are focusing on ad sales, and it’s rewarding to witness teams working passionately toward this goal. However, behind the scenes, we’re enhancing the content discovery experience, which aims to amplify the effort Ted’s team puts into content creation to deliver more value to our global viewers.

Okay. Great.

Thanks, Doug. Since you didn’t ask, I’ll take a moment to discuss Q4 content.

Go for it.

The Watcher is already showing enormous potential. We have returning seasons of The Crown, Emily in Paris, Manifest, Dead to Me, Firefly Lane, Ginny and Georgia, and an origin story from the Witcher world. We also have a new action series starring Noah Centineo called The Recruit, Tim Burton's debut series with Wednesday, Guillermo del Toro's Cabinet of Curiosities, and renewals of successful international series like Alice in Borderland, Barbarians, and Elite—all in Q4. We have much work to accelerate revenue growth but remain pleased with our engagement levels and the new hit series and films we’re providing at excellent prices, especially in these economically challenging times. We stood up an ad product in six months amid tremendous demand, and our partnership with Microsoft has facilitated this effort, allowing our basic with ads tier to welcome a new audience attracted to our robust content at a lower price. Looking forward to an incredible Q4 as we continue to expand in film and television streaming.