Netflix Inc (NFLX) — Q2 2023 Earnings Call Transcript

Hello, and welcome to the Netflix Q2 2023 Earnings Interview. I'm Spencer Wang, VP of Finance, IR and Corporate Development. Joining me today are Co-CEOs, Ted Sarandos; and Greg Peters; and CFO, Spence Neumann. Our interviewer this quarter is Jessica Reif Ehrlich from Bank of America. As a reminder, we'll be making forward-looking statements and actual results may vary. Jessica, I'll now turn over the call to you for your first question.

Thank you. Well, let's start with the top of the conversation regarding not one, but two strikes. Can you give us your views of how this affects your business on a practical basis? How far out does your original content take you, and how much of the content spend do you think gets pushed from this year into next year?

Thanks, Jessica. Good afternoon. Thanks for the questions. Let me start by making something absolutely clear. These strikes are not an outcome that we wanted. We make deals all the time. We are constantly at the table negotiating with writers, directors, actors, and producers across the industry, and we very much hoped to reach an agreement by now. On a personal level, I was raised in a union household. My dad was a member of IBEW Local 640 as a local union electrician. I remember his local because that union was very much a part of our lives when I was growing up. I also remember my dad being out on strike multiple times. That takes an enormous toll on families, both financially and emotionally. Nobody here took any of this lightly, and we've got a lot of work to do. There are a handful of complicated issues. We're super committed to reaching an agreement as soon as possible—one that is equitable and enables the industry and everyone in it to move forward into the future.

In terms of content, how much original content do you have to run out? At a certain point in time, you probably will.

Look, we've put some of our upcoming content in the letter. In the last call, we noted we produced heavily across all kinds of content: TV, film, unscripted, scripted, domestic, English, and non-English. All those things are true. But the real point is we need to get this strike to a conclusion so that we can all move forward.

Absolutely. So let's move on to password sharing, which is something everyone on the call wants to hear about. Could you give us a kind of State of the Union—what progress have you made to date and when will the rollout be complete?

Yeah, Jessica. We've worked really hard, iteratively over many months—really even over 1.5 years—to find an approach that we thought was a good product experience for most consumers. That includes features they wanted, such as transferring profiles and viewing history to a new account, easy ways to manage devices and account access, and purchasing an extra membership for a loved one. We've done a good job at building those features while ensuring Netflix gets reasonably paid when we deliver entertainment. As of today, we've now launched that experience in almost all the countries we operate in, and we’re seeing that it's working. We're positive in terms of both revenue and subscribers relative to pre-launch in all our regions. However, it's important to note that the business impacts will roll in over several quarters, as interventions are applied gradually.

Is there a way to think about segments of borrowers who have yet to convert? It feels like there's another wave coming, or maybe several waves. Maybe college students who are home for the summer and will go back in August or September. I don't know if mobile devices have been shut off yet. Anecdotally, many people who are not on mobile devices have said they haven’t been cut off yet. Can you help us think through that?

Yes, there are components of this based on behaviors and how we've organized the product experience. These effects will happen over time. We'll see the interventions broaden to more of those cohorts gradually. Additionally, we see differential engagement across that borrower population. Some borrowers use the service every day and are likely to transfer to their accounts soon, while others are less engaged. It will take longer to convince them to move over with compelling stories, TV shows, and films. Both of those dynamics distribute the business impact from this product experience. So we are seeing effects right now, but expect to see additional impacts over the next several quarters.

Can you provide any color on the results, such as what percent have converted to paying what plan? How many more members compared to subscribers? Your subscriber numbers were great this quarter, but there are also add-ons to households. Can you help us understand that and if people changed plans?

Generally, what we see is these are well-qualified members. In other words, they are choosing plans and engaging at rates that have retention characteristics similar to higher tenure members. That’s a broad way to think about those borrower cohorts. We expect the most engaged, well-qualified borrowers to convert first, but beyond that, I won't comment on more specific numbers.

Can we think through how much of the ARM growth in UCAN comes from add-on members to existing accounts versus new subs signing up for higher-priced plans? It sounds like ARM will accelerate in the second half as you get further along with password sharing. Is that correct?

Spencer, do you want to take this one on?

Sure. Broadly thinking about our revenue for Q2 and going forward, we delivered revenue in line in Q2 with our expectations. We're on track to accelerate that revenue in Q3 and further accelerate in Q4. Our objective around revenue acceleration is clear, and we're set to deliver on it. Our revenue growth is driven by new paid memberships, particularly from the paid sharing rollout. We're expecting that impact to build over several quarters as we see growth.

You've had another surprise over the last couple of weeks, which seems like it could drive ARM positively—that you dropped the basic plan in Canada and you've just announced that in the U.S. and UK. Are there plans for the rest of the world? Has the response in Canada driven what you hoped for? Do more people go to the advertising tier? Also, how long do you think it will take for the drop to have the most impact?

We view this as a continuation of our long-term strategy, focusing on optimizing various factors, including pricing and features. We want to give consumers access across various price points so that more people can enjoy the great stories we offer. The entry prices in the U.S., U.K., and Canada provide an amazing entertainment value and are attracting healthy sign-ups. After dropping the basic tier, we see that folks sort into two categories: some take the ads plan, while others move to the standard plan. We’re rolling this out iteratively and learning about impacts in real time.

For your new members from password sharing, are there noticeable differences in churn?

I would say, as I mentioned before, the members signing up right now are well-qualified individuals familiar with Netflix. They demonstrate retention characteristics and sharing behaviors similar to higher tenure subscribers, which is good for retention.

Can you talk about trends in ARM, particularly with the basic ad-free tier adjustments in Canada and other countries? What are you seeing in the numbers?

Our FX neutral ARM was down 1% in Q2, and we expect similar results in Q3, remaining flat to slightly down. This is mainly due to limited price adjustments in major revenue markets. Over time and in the medium to long term, we expect ARM to benefit from price adjustments, ads, and the extra members we discussed. However, both of these are still early.

Moving on to advertising—could you give color on innovative or non-traditional offerings? One of the things you mentioned was offering advertisers the ability to go into the top 10, which provides incredible reach. Can you elaborate?

Stepping back, we have work to do to grow the ads business, and our first priority is scale. We know that reach is a paramount consideration for advertisers. We grew ads plan membership nearly 100% quarter-over-quarter, a positive trajectory, as Spence mentioned. Our goal is to implement solid advertiser-facing features, including verification and improved measurement and targeting, which are essential for serving them effectively. We're also focused on blending unique capabilities that can deliver a premium ads experience on CTV, such as the top 10 feature you mentioned.

Has there been any change to advertising ARM since last quarter when you said advertising ARM was at least as high as standard, indicating that advertising-only parts were $8.50 or more?

There’s been no change. Our overall ads ARM continues to be higher than basic ad-free globally, as well as higher than standard ad-free in the U.S. We are pleased with our per-member ad economics and see good opportunities for growth in this space.

Can you tell us about your initial upfront advertising performance? What has the reaction been, especially given the soft overall advertising environment?

It's great to meet with so many advertisers and hear their needs. While the general market is soft, we benefit from our relative size, which allows us to manage our inventory effectively. We're seeing good demand and progress on the upfront. Our focus now is to quickly add advertiser features that meet their needs as we scale up our inventory.

What tools and how much time do you need to invest to build your ad-tech infrastructure?

It's a gradual ramp. We have tens of engineers working on this, and Microsoft has even more on the team, continuously delivering features in collaboration with the advertisers' needs at the forefront.

Is there a time frame to achieve scale in terms of technical capabilities?

Both scale and tech capabilities develop gradually. Scale is on a good trajectory; we've seen 100% quarter-over-quarter growth. For technical features, we’re working through a long list in an iterative fashion, continuing to progress every day.

What’s your vision for the advertising contribution? You've mentioned wanting it to be 10% of revenue. Given the decline of linear, are you reconsidering that to be higher?

We have a long way to go to reach even 10%, so we're not rushing to adjust that goal. We see advertising as a meaningful part of our business and will focus on achieving that target, but we must prove out the business model over time.

Where do you think the pool of ad dollars will come from, even if you have extraordinary capabilities?

Over time, we anticipate drawing from both linear and digital ad dollars. For now, we're focused on capturing brand-focused TV advertising dollars, which is a significant opportunity.

It’s about developing a model that is better than TV. We aim to blend linear and digital approaches to capture both revenue streams over time.

Has engagement changed in the past quarter? Are there noticeable differences between the tiers?

There are differences across the tiers. More qualified, higher engagement generally translates to better tier participation. However, we haven't observed significant changes over time. We're seeing strong engagement across all our tiers, including our ads plan.

As streaming continues to grow, we’re capturing a larger share of viewer time in a competitive environment. We've consistently had the number one show and film on streaming this year. The opportunities for engagement are enormous as we continue to develop our capabilities.

Can we discuss your free cash flow? You had an extraordinary second quarter, and you mentioned the outlook for Q3. Could you address the underlying dynamics? Talk a bit about content spend and other investments?

Sure. Our cash flow forecast improved for 2023 due to higher certainty with the paid sharing rollout, production timing adjustments, and the impact of the strikes. There may be some lumpiness between 2023 and 2024 due to ongoing strikes, but we expect substantial free cash flow in 2024. Overall, we're past the most cash-intensive phase of our original programming strategy.

What's your content spend outlook for the next few years? What will be normal post-strikes?

We're keeping our cash content spend roughly flat from 2022 through 2024, with lumpiness due to strikes. We're optimistic about returning to current levels of spending in 2024. We're focused on responsible growth in our cash flow as we look ahead.

Can we talk about uses of free cash flow and potential M&A? There are many distressed assets in media, and you've seen the lowest multiples in memory. What assets might interest you?

We’ve traditionally been strong builders over buyers. Our M&A activity would focus on IP development for our members. We’ll look at opportunities to access pools of IP for content development, but we’re cautious about distressed assets.

Given the extensive library you've developed over 10 years, would you consider selling your library content to others?

We believe we provide unbelievable value to our members by offering content exclusively on Netflix. Other markets don’t support the audience we have, and we see strong viewership when new content arrives—often reviving older titles. The depth and richness of our library enhance our offering for subscribers.

Can you talk about your live strategy, including any experimentation in sports? You've reportedly outbid ESPN for some content. Can you touch on the live sports angle?

Our position on live sports remains unchanged. We're excited about the success of our sports-related programming. Our sports-adjacent content has introduced new audiences to sports through compelling storytelling. We're exploring opportunities without getting involved in the complexities of live sports licensing economics.

Great. Well, thank you, Ted, for that answer. Thank you, Jessica, for your questions, and thanks to the audience for tuning into the video interview. We look forward to speaking to you all next quarter. Thank you.