It reaches 1 billion viewers - and now, this media giant wants its slice of the advertising pie

In a world where interest rates are higher and wallets tighter, there is no doubt that consumers are cutting back, feeling dourer about the state of the global economy. All the news around torrential rain and the war in Ukraine is when we need an escape the most. It used to be Saturday night telly, then it became the movies. These days, it's called a Binge, and analysts are split on whether the most notable name of them all can weather this storm.

With this in mind, it's safe to say today's earnings report from media giant Netflix (NASDAQ: NFLX) was the Heartstopper for Wall Street. But the company leapfrogged all expectations - doubling analysts' estimates for new paid subscriptions. It beat the consensus on the top and bottom line, with CEO Reed Hastings arguing the worst is over for the consumer slowdown.

All eyes now turn to the ad-supported version and how it could change (or salvage) the fortunes of its balance sheet. The analysts are split on whether it will make the changes the company so badly needs to see happen. Benchmark analyst Matthew Harrigan has one of the many sell ratings on the street - arguing the medium-term risks are “geared to the downside.” Then again, Stranger Things have happened before.

So are people willing to stay on for Squid Game II, even if it means having to see advertisements? Or is Netflix still on track to lose The (streaming) Crown?

We'll delve into all these topics and plenty more besides with Lachlan Hughes from Swell Asset Management. Plus, we'll get his views on what else he'll be watching out for as the US big tech reports begin to occupy the Spotlight.

Netflix's Q3 earnings

• Revenues of US$7.93 billion 
• Net income (profit) of US$1.4 billion
• EPS of US$3.10/share
• Operating margin of 19.3%
• Revenue in the latest quarter was up 6% but would have been as much as 13% higher if the US Dollar was not so strong.
• Global subscribers +2.4 million to 223 million; estimates it could add 4.5 million subscribers by the end of the year.

Note: This interview took place on Wednesday, October 19th, 2022. Netflix was a top contributor to the Swell Asset Management'Global Fund last month but is only 2% of the fund's composition.

It was definitely execution. Returning to subscriber growth is very important but also beating guidance, which I thought was very good. The key thing for me was the work they've done in bringing that ad-supported tier to market. It's been an incredible effort finding a partner in Microsoft, then getting it to start next month.

It was deliberate to work it as hard as possible. It's quite an achievement to get it squared away in two quarters. It was only a couple of quarters ago they had even mentioned advertising and Reed [CEO Reed Hastings] has been very negative about advertising for a long time. To make the adjustment and offer this choice to consumers, then bringing the execution, and having it ready to go for next month is an incredible achievement.

What was the market’s reaction to this result? Was this an overreaction, an underreaction, or appropriate?

Appropriate

There were two key things - firstly, the advertising opportunity. The unit economics of the ad-supported tier will be roughly equivalent to the basic tier. So what that means is you get an equivalent amount of revenue to the basic - so we know it's accretive. It will really open up the market for Netflix. A lot of their peers already have ad-supported tiers. We know people miss or are unable to price the cost of time. What it means is a bigger market and that's a good thing for them. 

The other part which they touched on - they have 100 million subscribers sharing passwords at the moment. Coming up with a clear plan to take a small amount of money off these password sharers, and this comes at a very high margin. If they manage to take a couple of dollars from each of these subscribers, it's a meaningful contribution to Netflix's revenue growth. We know they will start to move on that in 2023, and it provides good momentum for the company.

Were there any major surprises in this result you think investors should be aware of?

We know that broadcast and pay TV are decelerating very quickly. This is a positive for Netflix as they look to capture more of this advertising dollar. The decline in linear (TV) is something we've seen for a long time but I feel like it's accelerating. This is a very good thing for them. 

Lastly, Netflix reaches a billion viewers. They have 225 million subscribers but it reaches a billion viewers. The result really speaks to the reach of the platform, and that comes in a couple of places - if you want to attract great talent and great creators. It always surprises me what a large opportunity set Netflix has going forward.

Follow up: Are you surprised Netflix has withdrawn subscriber guidance going forward?

No, I'm not. It becomes less relevant going forward. They're just not guiding. They'll still supply the number of subscribers, just not guide on it. This is important because as they start to monetise the password sharers, that won't increase subscribers. It becomes less relevant. As the advertising business becomes bigger, membership growth is going to be less of a driver. The primary driver will then be advertising dollars. 

It's not a surprise. It makes sense. I would have actually been disappointed if they didn't give subscriber numbers going forward.

During this period, coming out of COVID-19, where they added a significant number of subscribers. Now the world has reopened, it's been very volatile and the subscriber numbers are hard to get right. It just speaks to the enormity of the challenge management has in guiding subscriber numbers. I'm happy they're just going to give that going forward.

Now, it's about extracting revenue from people enjoying the service.

Would you buy, hold or sell Netflix on the back of these results?

Buy

I'd buy it - it's a very good business. For the long-term fundamentals, the scale is generally underappreciated. They have the lowest cost on a per-subscriber basis, they're able to leverage their massive content budget, and they're able to attract great creators because they want to go where the eyeballs are. 

In the short term, we were always going to be dealing with competition. A number of peers have brought their offerings to market in the last 18 months. This has seen some people sign up for their competitors. Going forward, subscribers will look at the content and the value that is there. They will make a choice, and if they have to, Netflix will be a beneficiary of that.

I think they're in a very good place to compete. 

What is your outlook on the wider US media and streaming sector? And what are the biggest risks investors should be cognisant of?

If you look at the history of this industry, we've really gone from cable bundles. It's now unbundled with streamers going directly to the market. The next phase, I think, will be the rebundling and I think you'll see some of the smaller competitors who can't make a fist of it look to bundle so they can compete. Long term, it's going to be just the heavyweights (Disney, Netflix) but it's these guys who are best positioned to complete over the long term. 

We'll continue to see a decline in linear TV and advertising dollars will shift. I think you'll continue to see innovation in the type of advert formats that are provided. Disney has the benefit of a broadcast business already, so they've got the experience in advertising so they will probably make that transition faster than Netflix. But Netflix has flagged they will take a "crawl, walk, run" approach to growing those dollars. The partnership with Microsoft represents its crawl phase. We'll see them continue to innovate over time.