When it comes to streaming movies and TV shows, consumers are now flooded with options. More than 80 different providers are operating worldwide, many of which offer their own unique original content. Netflix (NFLX 1.51%) is an industry pioneer, and it still leads the pack by a small margin.
But it's becoming increasingly difficult for the company to extend its advantage over the competition, especially because some of the best content creators, like Disney, have pulled away from the licensing model to launch streaming platforms of their own.
Netflix is trying a number of things to accelerate its subscriber growth, including a crackdown on password sharing and the introduction of a cheaper, ad-supported subscription tier. Both of those initiatives are still in their infancy, but investors learned a little more about their successes and failures so far in the second quarter of 2023. Here are three of the biggest takeaways.
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1. Paid sharing is working!
Password sharing has long been a thorn in the side of Netflix executives because they believed they were missing out on subscription revenue from up to 100 million customers. Those customers were simply borrowing the Netflix credentials of a friend or family member entirely free of charge -- but the free ride has officially come to an end.
A paying household on the $15.49-per-month standard plan or the $19.99-per-month premium plan can now add an extra member for an additional $7.99 per month, which gives Netflix an opportunity to monetize a pool of users who already love the platform. In the second quarter, the company said this arrangement was active in over 100 countries, which represent 80% of its revenue base.
It said revenue in each region is higher than it was before the launch of paid sharing, and signups were already outpacing cancellations despite fears the move could upset customers. But here's the best news: Netflix added 5.9 million new subscribers overall in just the three months since the first quarter, crushing Wall Street's estimate of 1.7 million.
Its subscriber base topped 238 million, marking an 8% increase year over year, which was an acceleration compared to its 5.5% growth rate in the same quarter of 2022. So far, Netflix's paid-sharing strategy is a winner.
2. Building an ads business from scratch isn't easy
Netflix resisted entering the advertising business for years, but in 2022, it finally decided to launch a new subscription tier supplemented by ad revenue. It's designed to increase the company's addressable market by coming in at a lower price point of $6.99 per month, and the good news is that it's already generating more average revenue per user than the $15.49-per-month standard plan.
But traction has been relatively slow; the number of signups doubled in Q2 compared to Q1, though it was off a low base. Netflix reported the ad tier had roughly 5 million subscribers in May, which means it represents less than 1.5% of the total subscriber base, making it an inconsequential contributor to revenue right now.
The company's goal is for the ad tier to eventually account for 10% of total revenue. Last week, it quietly killed its (ad-free) basic plan, which was priced at $9.99 per month, presumably to entice new signups to consider the ad tier instead because it drives more revenue.
In its Q2 report, Netflix said that "building an ads business from scratch isn't easy" and discussed exactly how much work is ahead. In the conference call with investors, management said the first goal is to continue building the ad-tier subscriber base because that will ultimately attract businesses to the platform -- more users equals more eyeballs which equals more ad dollars.
Netflix's second job is to build the technology to make advertising more attractive for those businesses. The company is rolling out measurement, targeting, and verification tools so advertisers know how much reach they're getting for their marketing dollars. Then there are more advanced features, including the ability for advertisers to target Netflix's top-10 shows, which guarantees them placements in the platform's most-watched content.
3. It's becoming harder for Netflix to grow its revenue
While all of the above sounds great for Netflix's long-term outlook, it's clear these changes are merely driving incremental growth. The days when this company would consistently grow its revenue by double-digit percentages are likely in the rearview mirror.
Even though streaming continues to increase as a percentage of consumers' TV screen time, the competitive environment is simply too fierce to expect Netflix to improve its market share while also acquiring users in its higher tiers to drive more revenue.
That phenomenon was crystal clear in Q2. While Netflix grew its subscriber base at an accelerated pace, revenue grew by just 2.7% year over year. That was a significantly slower rate than the 8.6% revenue growth it delivered in the year-ago quarter. Why is that important? Because growth impacts the price an investor is willing to pay for its stock.
While Netflix stock is still trading well below its all-time high, it has surged 144% from its 2022 low point. Based on the company's $32.1 billion in trailing-12-month revenue and its $190 billion market capitalization, its stock trades at a price-to-sales (P/S) ratio of 5.9 as of this writing, which has also more than doubled.
That means Netflix has mostly benefited from the expansion of its multiples rather than an increase in value based on higher revenue growth. It means investors are willing to pay a higher valuation for Netflix now based on improved conditions in the broader stock market, as opposed to anything the company has done.
To be clear, I'm not calling for a drop in Netflix stock right now. But in order for it to generate further upside, the company will likely have to prove to investors that paid sharing and its ad tier are capable of driving meaningful long-term growth. Otherwise, it will become increasingly difficult to justify Netflix's valuation.
