Netflix: No Need to be Overly Enthusiastic Despite Sound Performance

On the early morning of July 20th, Beijing time, Netflix (NFLX.O) announced its Q2 2022 financial report. The repeated underperformance in the past two quarters has taken a toll on its stock price. The market did not have high expectations for Netflix's Q2 performance, especially in terms of paid user growth, which was impacted by inflation, offline competition, intensified competition, and foreign exchange rates. However, the actual results were not as pessimistic as the market had anticipated.

Although the data and Q3 growth outlook were only mediocre in terms of performance, the "better-than-expected" results were a surprise due to the extreme pessimism in the market's expectations for this quarter's US stock earnings. Yesterday, the market seemed to have adjusted its expectations, and Netflix rebounded nearly 6 points. After the financial report was released, its stock price continued to rise by 7 points after-hours, dispelling the haze of "knee-jerk reactions" since the beginning of the year.

Specifically, here are the performance indicators:

(1) For the entire Q2 report, the most eye-catching indicator was the user churn rate (970,000), which was lower than the management's guidance and market expectations (2 million), as well as the more pessimistic expectations of some core investment banks (2.5-3.5 million). From different regions, the expectations gap mainly came from the emerging regions of Latin America and the Asia Pacific. Regarding the user churn rate in North America, it has been visible for two consecutive quarters and the market's ceiling potential for paid users is already over 80 million with Netflix's penetration rate having exceeded 90%.

Dolphin Analyst believes that the reason why the number of paid users for this quarter exceeded market expectations and previous guidance was mainly due to the drive of high-quality hit content. The fourth season of "Stranger Things," which was launched at the end of May, once again set a new record in popularity, with a total viewing time of 1.3 billion hours, surpassing the previous clickbait drama "Bridgerton" series to rank first on Netflix's English drama playback chart.

However, management's growth guidance for paid users for the next quarter is also conservative, with net additions of only 1 million, lower than the market consensus of 2.4 million. The market's relatively "optimistic" logic is that the impact of offline returns and price hikes will gradually dissipate as time passes, and will be gradually absorbed in the second half of the year. Management did not elaborate on the derivation logic of the guidance data, and Dolphin Analyst believes that inflation and competition may be the main reasons for their conservative expectations.

(2) Total revenue for Q2 was nearly 8 billion yuan, a year-on-year increase of 8.6%, reaching a growth rate of 13% after excluding the impact of the appreciation of the US dollar. Revenue from streaming media increased by 8.7% YoY, mainly driven by the growth of ARPU for single users. The DVD business, as a sunset industry, has been declining at a rate of about 20% and its revenue share is already very small.

Management expects revenue for Q3 to be 7.8 billion yuan, a year-on-year increase of 5%. This figure is also suppressed by exchange rate fluctuations, and after excluding the impact of exchange rates, the growth rate is 12%, implying expectations of relatively stable business growth, which will not be severely impacted by factors such as inflation and competition. The total revenue guidance is still lower than market consensus (~8.1 billion). Dolphin Analyst believes that there are different factors that need to be given more attention to in the second half of the year for different user markets:

1. In mature markets such as North America, inflation's impact on user consumption needs to be given more attention, while competition has slightly eased as peers have also started to raise prices recently.

2. In emerging markets such as the Asia-Pacific and Latin America regions, the impact of competition is greater. Peers are penetrating quickly outside the United States and are also investing heavily in content, and emerging markets are driving Netflix's user growth.

(3) In terms of operating quality, the company achieved an operating profit of 1.58 billion in the second quarter, a year-on-year decrease of 15%, and a significant decrease of 19.8% from the previous quarter's profit margin due to a decline in gross profit margin.

The company explained the change in cost structure as non-operating costs of severance pay (Netflix laid off nearly 500 people in the second quarter) and impairment of some office space, which totaled about 150 million. After adding back these expenses, the gross profit margin was basically in line with market expectations. In addition, the company attributed the increase in costs to the impact of exchange rates. Excluding these factors, the actual profit margin exceeded the company's internal expectations.

In addition to the above factors, Dolphin Analyst believes that the increase in content costs is also a factor. At the beginning of the year, the company provided a guidance range of 19%-21% for the full-year operating profit margin, so we may continue to see a decline in profit margin in the second half of the year due to the increase in overall content costs and the impact of exchange rates caused by intensified competition.

(4) In the second quarter, due to the payment of the acquisition cost of Next Games studio, cash flow pressure increased. Non-GAAP free cash flow was close to 13 million US dollars, a significant decrease from the 800 million in the previous quarter. However, the management mentioned this time that the full-year free cash flow for 2022 is expected to be 1 billion US dollars, which means a net inflow of 200 million in the second half of the year.

At the same time, the company's "buy-buy-buy" approach has not stopped, and coupled with investment in content that is progressing as planned, it can be seen that the company still has some confidence in the profitability in the second half of the year.

Dolphin Analyst will share the conference call summary with the dolphin user group through the Longbridge App. Interested users are welcome to add WeChat ID "dolphinR123" to join the Dolphin Research Group and get the conference call summary as soon as possible.

Other operating indicators can be compared with market expectations as shown in the following table:

Dolphin Analyst Opinion

Starting from the guidance thunderbolt in the fourth quarter of last year, Netflix seems to have gradually fallen into the quagmire of "faith collapse." The intensification of competition and the return of offline demand after the epidemic are direct causes of breaking the Netflix belief myth. In the first half of the year, the entire U.S. stock assets were rehearsing the valuation shrinkage under the expected rate hike, and growth stocks like Netflix naturally had no escape from being targeted. Actually, the performance of this Q2 was average, but given the market's uniform pessimism about the US stock earnings season and the low valuation, it is understandable that Netflix rebounded emotionally.

However, Dolphin Analyst reminds us that behind the carnival is still a cold reality. The competition in long video is not easing, and Netflix's business situation has not changed. If it evolves into a recession in the second half of the year and consumer demand shrinks, whether performance can support the valuation is a matter for investors to pay attention to.

Specific data for this earnings report

1. Hottest drama drives growth, user churn lower than expected

In Q2, Netflix's global subscription numbers were 221 million people, with a net loss of 970 thousand on a monthly basis, which was better than the management's guidance and market expectations (~a reduction of 2 million), and even more cautious than the original expectations of core investment banks. Although the third quarter's guidance for user growth of 1 million is still lower than the market's expected 2 million, this unexpected delight certainly results from the market's overly pessimistic mood.

Geographically speaking:

1. Users in mature markets such as North America and Europe continued to lose ground, with losses of 1.3 million and 770 thousand, respectively, showing signs of peak penetration.

2. Asia-Pacific and Latin America, two emerging markets, mainly account for user growth, increasing by 1.08 million and 10 thousand, respectively.

Apart from different stages of market development, inflation in North America and price increases at the beginning of the year were also key factors leading to user churn. However, it is worth mentioning that the growth in Latin America was somewhat unexpected. In many countries there, inflation is so high that Netflix, which could not hold out, had to significantly raise prices. However, users did not churn as expected by the market, but instead remained stable.

Dolphin Analyst speculates that this may be related to Netflix's recent launch of the "account sharing package" in Latin America: A family account can add 2-3 new users at an additional, lower price.

The outperformance of Q2 is still mainly due to explosive content. The fourth season of "Stranger Things," which was aired at the end of May, has not been online for less than 2 months, but has already surpassed the total play time of any other Netflix English series and crushed the second-place "Bridgerton." Keep in mind that "Bridgerton" seasons 1 and 2, which were popular for two whole years from 2020 to 2021, were repeatedly mentioned by Netflix in previous earnings reports.

For future user growth, Netflix is still focusing on its “account sharing” feature that can stimulate up to 100 million potential users. From the regions where Netflix first implemented this feature, account sharing mainly occurs in emerging markets. Even though it is not insignificant in scale, the value per single user is not high, so the resulting revenue increase for Netflix may not be significant as well. Therefore, as Dolphin Analyst mentioned multiple times in the last quarter's financial report, the era of high growth in Netflix's long-form video business is gone. Investors should quickly accept Netflix's logic shift from a growth stock to a value stock. In other words, the demand for profit will gradually become higher than the demand for user growth, and this depends on Netflix's ability to "raise prices" for existing users.

Of course, Netflix's recent actions indicate that it is not willing to stop its high-growth momentum, especially in its investment in games. From November last year to now, Netflix has released nearly 24 licensed games. Netflix's purpose in making games is to expand its membership user base. However, it's too early to draw conclusions at this moment. From the current perspective, Netflix's games are mainly casual games, and because Netflix's commercial model is to include game content in its membership system, Dolphin Analyst believes that optimism for the incremental space that its games can bring should not be too high.

Second, after excluding exchange rate effects, growth is still mainly driven by "price increases."

Netflix's Q2 total revenue was 7.97 billion, an increase of 8.6% year-on-year. For Netflix, which has 60% of its revenue from overseas, the strong US dollar significantly lowered its total revenue. Calculated at a constant exchange rate, the Q2 growth rate is 13%, which is stable compared to the previous quarter's 14%. This shows that under the full opening of global offline activities in Q2, Netflix relied on hit TV series and overall revenue didn't fall short.

However, when scrutinized in detail, in the case of a user loss of 970,000, revenue growth is mainly driven by the price increase effect. The global comprehensive single-user payment ARPU increased by 2% year-on-year, but if the exchange rate effect is excluded, the actual ARPU growth rate is 7%.

North America has a high value per single user, and the price increase effect is also the strongest reflected in this financial report, with ARPU increasing by 10% year-on-year. However, if you only look at the price increase situation in local currency, the situation in Latin America is more obvious, but the price increase in Latin America is a passive one forced by high inflation.

The price increase effect in North America at the beginning of the year began to appear in this quarter. Although it will increase user loss, Dolphin Analyst understands that ESPN+, owned by Disney, also announced a price increase starting in August, and the increase is not small. (The price of the standard version has increased from $6.99 to $9.99). Therefore, the pressure on user growth caused by Netflix's price increase at the beginning of the year can be relieved after its peers also raise prices.

Three, competition mainly focuses on emerging markets

2021-2022 is the content cycle of Netflix, and many explosive hit dramas have been broadcasted, which is also the highlight moment of Netflix in the past two years. According to Nielsen data, from September 2021 to May 2022, Netflix's viewing time increased from a market share of 6.6% in June 2021 to 7.7%. However, in fact, the trend of intensified competition among peers has already emerged since the second quarter of last year.

In the last quarter's financial report, Dolphin Analyst listed several recent competitive dynamics of major long video giants, including: 1) award-winning self-made/invested film and television content; 2) investing heavily in filming well-known IP film and television series; and 3) mergers and acquisitions between second-tier companies.

Since the second quarter, Netflix's peers have been rapidly penetrating non-US regions, among which Disney+ and Paramount+ have made the greatest efforts, mainly attacking the European, Central Asian and African regions. Invisibly, they have also exerted more pressure on Netflix with funding shortfalls.

Four, content investment progress resumes, a new round of investment cycle may start in the second half of the year

After the deceleration of content investment expenditure in the previous quarter, the growth rate of content investment in the second quarter has resumed, which may be related to the lifting of epidemic lockdown.

(1) As of the end of the second quarter, Netflix's content asset size is 32.5 billion. Although the current content cash expenditure growth rate is not high compared with the same period of last year, it is already growing month-on-month, indicating that content investment is gradually recovering.

(2) In addition, the management's expectation for the content investment scale this year is still maintained at 17 billion, of which 8.4 billion has been spent in the first half of the year. According to the trend of investment being generally higher in the second half of the year than in the first half of the year in previous years, this year's investment may exceed expectations.

(3) If we look at the content amortization growth rate and content investment expenditure growth rate, the investment growth rate in the first half of the year is lower than the amortization growth rate, indicating that Netflix is ​​rapidly reducing its inventory, and at the same time, it also means that a new round of investment cycle may need to be started in the second half of the year.

Second-quarter profits for Netflix declined on a quarterly basis, mainly due to the rising costs of content and some non-recurring expenses such as severance pay and asset impairment in the second quarter. In addition, the company explained that foreign exchange had an impact. Furthermore, there is a trend of rising content costs from the proportion of content amortization costs to streaming revenues. Ultimately, the operating profit margin was 19.8%, a significant decline on a sequential basis. However, the management gave a profit guidance of 19% to 20% for the whole year at the beginning of the year, so the market should have expected a decline in profit margin for the remaining three quarters after the Q1 report was released.

[Dolphin Analyst] "Netflix" historical articles:

In-Depth Analysis

February 16, 2022 In-depth analysis "Consumer Internet "roll king" competition, Meta, Google, Netflix fight with bayonets"

November 23, 2021 In-depth analysis "A long video melee is coming, the American version, Netflix, Disney is in trouble?"

Earnings Season

April 20, 2022 Conference call "Focus on how to increase revenue, the actual "exposure" lacks confidence in user growth (Netflix conference call summary)"

April 20, 2022 Earnings Review "A 25% overnight drop, Netflix's logic collapsed"

January 21, 2022 Conference call "Management said guidance expectations are lower due to the uncertainty brought by the pandemic (Netflix Q4 earnings conference call transcript)"

January 21, 2022 Earnings Review "A 20% crash? Netflix has become a copycat of iQiyi"

October 20, 2021 Conference call "[Ambitious Netflix's next goal is to learn from "Disney" (Q3 earnings conference call transcript)](https://longbridgeapp.com/topics/1228298? invite-code=032064)》

October 20, 2021 Financial Report Review "Netflix: The Return of the Streaming Giant, Accident or Destiny?"

July 21, 2021 Conference Call Minutes "Netflix Q2 Conference Call Summary"

July 21, 2021 Financial Report Review "Guidance Remains Cautious, When Will the King of Post-Pandemic, Netflix, Return? | Dolphin Analyst"

April 21, 2021 Conference Call Minutes "Netflix Q1 Conference Call Q&A: Let's Take a Look at Management's Response to User Growth Issues"

April 21, 2021 Financial Report Review "After the End of the Pandemic Bonus Period, Netflix's User Growth is a Bit Bumpy"

Risk Disclosure and Statement for this Article: Dolphin Analyst Disclaimer and General Disclosures