Netflix (NFLX -9.09%) reported first-quarter earnings this week, and the market didn't appear to love the results. Shares were down 3.2% the following day.
While the streaming-giant's profit came in above expectations, top-line revenue came in slightly below, at 3.7% growth. Of note, foreign exchange hurt both revenue and profit margins. Growth would have been 8% ex-currency movements, and operating margins would have been higher.
Still, investors should view Netflix in a different way now. Whereas the company used to be a high-growth stock that traded based on subscriber and revenue growth, it's now transitioning to a moderate-growth but higher-profit company.
On the bright side, Netflix's bottom line could show an explosion of profitability in the year ahead. While the transition may be rocky, three big initiatives are kicking in this year that should lead to higher profit margins in 2023 and beyond.
1. Advertising could be insanely profitable
First, Netflix just rolled out its ad-supported tier in the fall of 2022. Fortunately, early signs point to this being a really good move by management.
In the first quarter, management noted engagement in the ad-supported tier was above company expectations. Even better, most of the ad-supported viewing is in incremental accounts, with "very little" switching from premium to ad-supported tiers.
Perhaps more importantly, the monetization from ads is looking up. In the U.S., average revenue per member (ARM) for the ad-supported tier, including both the lower subscription and ad revenue combined, exceeded that of subscription-only plans. Right now, Netflix only has its "basic" plans in 780p resolution qualifying for ad support, but since ads are going so successfully, Netflix is going to expand ads to 1080p resolution plans, too.
CFO Spencer Neumann said on the conference call that advertising adds an incremental 50% margin profit right now on top of subscriptions. Margin should go higher as Netflix builds out more programmatic advertising capabilities in tandem with its ad-tech partners and scales further.
Given the incremental and high-margin nature of ad revenue, the rise of ad-supported tiers at Netflix should be very good for profitability.
Image source: Getty Images.
2. Paid account sharing
As some may have heard, Netflix is finally cracking down on password sharing among its customers. But rather than the wholesale cancellations of subscriptions for any member outside the household, Netflix has devised a way to meet its customers halfway.
The company has tested a "paid sharing" feature in four countries last quarter, including Canada, New Zealand, Spain, and Portugal, after initially testing the feature in Latin America. The concept works exactly like it sounds: Existing Netflix subscribers can now add two people outside the household to an account for an incremental fee that's not as high as a regular subscription.
In Canada and New Zealand, the fee was $7.99 for two accounts, 3.99 euros in Portugal and 5.99 euros in Spain. The concept is not unlike adding members to a credit card account for a lower annual fee.
Management noted that when the plans were initially offered, engagement went down as some subscribers fell off accounts. However, in a short amount of time, those prior account "borrowers" were either added back as paid shared additions or became new subscribers themselves. In the end, Netflix netted out a greater amount of paid subscription revenue after the initial drop.
In the Q1 shareholder letter, management gave an encouraging preview for this feature, which will be rolled out to the U.S. in the second quarter. They wrote: "[I]n Canada, which we believe is a reliable predictor for the US, our paid membership base is now larger than prior to the launch of paid sharing and revenue growth has accelerated and is now growing faster than in the US."
Paid sharing should add virtually costless revenue to Netflix's results as paid additions are rolled out in the U.S. this quarter, further benefiting the bottom line.
3. Lowered content spend, and an upgrade to investment grade
Finally, management also noted it would be spending a bit less on content this year than the $17 billion it had initially projected last quarter. And now that the company is generating greater operating profits and free cash flow, Moody's upgraded the company's debt in the first quarter to Baa3, giving Netflix an official "investment grade" rating by a majority of leading ratings agencies.
Netflix will now have lower interest expenses when refinancing debt. When combined with management's controlled content spending in line with revenue growth, both initiatives should incrementally benefit the company's bottom line.
Netflix is now a bottom-line company
Netflix used to be a revenue-focused growth company, but investors should now look more evenly at the company's top and bottom lines. It forecasts operating margin to expand to 18%-20% this year, up from 17.8% last year, and for $3.5 billion in free cash flow, relative to $1.6 billion in 2022.
As the effects of ad-supported tiers, paid account sharing, and lower interest costs kick in, investors should expect margins to expand well beyond this year. At about 41 times this-year's free-cash-flow estimate, shareholders will need the company to show even more incremental profitability in the future. Fortunately, management appears to be executing quite well on that front.
