In early November, Netflix (NFLX 1.74%) fundamentally changed its DNA. The company, which had long touted its lack of commercials as a selling point, rolled out an advertising-supported streaming plan at $7 per month. This was arguably one of the most controversial moves in Netflix's history and one that gave both the bulls and bears ammunition.
Bulls argued that the vast majority of longtime subscribers were unlikely to switch to the less expensive ad-supported plan, having become accustomed to programming without commercials. Bears contended that cheaper is cheaper and Netflix would likely see a wave of defections as viewers sick of price increases would revolt and switch to the less expensive plan.
Turns out subscribers took the side of the bulls.
Image source: Getty Images.
It all "ads" up for Netflix this quarter
For the inaugural quarter with its ad-supported tier, management predicted that Netflix would add a total of 4.5 million subscribers in the fourth quarter, while analysts forecast 4.6 million. The results were far better than expected, with a whopping 7.7 million net additions, bringing its global total to roughly 231 million.
The company addressed the rollout in its quarterly shareholder letter, saying, "We believe branded television advertising is a substantial long term incremental revenue and profit opportunity for Netflix," and the early results seem to bear that out. The company went on to say that engagement among viewers on the ad-supported plan was consistent with members on comparable ad-free plans -- which was better than the streaming pioneer had expected. This suggests that the lower price point is driving incremental membership growth.
Management also noted there had been "very little switching" from other, higher-priced plans. This supports the assertion that the ad-supported tier is benefiting from the addition of new members, rather than from existing subscribers trading down to the cheaper plan.
Netflix also revealed for the first time that the ad-supported plan has "strong unit economics," which at a minimum are "in line with, or better than, the comparable ad-free plan, and will generate incremental revenue and profit." Investors are breathing a sigh of relief, as some feared the bumpy rollout of the advertising tier was a foreshadowing of problems ahead.
That's not to say it was all sunshine and roses. Netflix acknowledged as much when the company said (emphasis mine) that "it's still early days for ads and we have lots to do," specifically citing "better [ad] targeting and measurement."
The tale of the tape
Netflix investors have long understood that subscribers are the linchpin of the company's financial results and the additional subs helped fuel the robust financial results, with revenue and operating profit both higher than guidance.
Fourth-quarter revenue grew 1.9% year over year to $7.85 billion, more than double the 0.9% growth management had predicted. Operating margin of 7% surged past the 4.2% the company forecast. Net income of $55 million came in lighter than expected but was the result of a non-cash charge of $462 million, the unrealized loss of its euro-denominated bonds, which acts as a hedge. If not for that charge, profits would have far exceeded expectations.
Netflix initiates a change at the top
In a surprise move, Netflix announced that CEO Reed Hastings would be moving upstairs, assuming the role of executive chairman. Greg Peters, former chief operating officer, will join Ted Sarandos in the role of co-CEO. In a blog post, Hastings noted that their "complementary skill sets, deep knowledge of entertainment and technology, and proven track record at Netflix" made them uniquely qualified to serve as co-CEOs.
Hastings said that moves were part of Netflix's "succession planning," noting that founders often assume the role of executive chair when they "pass the CEO baton to others." The company also explained that the move "makes formal externally how we have been operating internally."
Netflix's future's remains bright
The news was all relatively bullish from an investor standpoint, and it appears there could be even more growth drivers ahead.
After testing its pilot plan in Latin America, Netflix plans to crack down on password sharing with the rollout of its "paid sharing" plan, which will begin in earnest later in the quarter. The initial test showed that while there were a small number of initial cancellations, these were more than made up for by the addition of standalone accounts from what the company called "borrower households." Netflix said near-term engagement could be "negatively impacted" but would rebound -- similar to the pattern that played out in Latin America.
Overall, Netflix's performance seemed to bear out what the company had suspected: The ad-supported tier resulted in incremental subscribers, the paid sharing plan will boost membership, and the company's growth would resume.
Oh, and did I mention that while it has rebounded slightly from all-time lows, Netflix stock is still a relative bargain, selling for just 4 times forward sales? This is particularly true given the early results of its foray into advertising and initial success at reducing password sharing.
It's a good day to be a Netflix investor.
