Editor's Note: Below is an full note from Communications analyst Andrew Freedman that he published to subscribers on 10/19/2021 after Netflix's (NFLX) 3Q21 earnings report. Freedman published his latest thoughts from here on sub trajectory and valuation in a note to subscribers this morning.

For access to the most recent Netflix note: Institutions please contact sales@hedgeye.comRIAs/Individuals please check out Communications Pro

FLASHBACK | A Lot of Uncertainty & Risk For Netflix (NFLX) To 2022+ - NETFLIX cartoonFIX

While 3Q21 paid member additions were a step in the right direction – the jury is still out whether we get back to ~25M annual member additions 2022-2025 (Factset consensus).

 EMEA net adds in 3Q21 of 1.8M still marks the lowest third-quarter in reported pre-COVID history (3Q17 EMEA net adds were 1.98M). LATAM 3Q21 net adds of 330k is well below 3Q19/3Q18/3Q17 of 1.49M/1.32M/1.25M. Meanwhile, UCAN is trending flat YTD.

Management is increasingly calling out higher market penetration, and that growth in Latam/UCAN will be harder to get. If we take the average Q3 seasonality % by region for ‘18/’19 and apply those %s to 3Q21 reported sub-additions, we get an annualized rate of global subscriber additions of 16.5M versus 2022 consensus of 24.7M and 17.3M in FY21. With UCAN, LATAM, and Developed Europe increasingly tapped out, and with greater competition, we have to have APAC/MENA/Africa to do the heavy lifting. And if we follow the growth curve/s-curve, it would be unusual to see a re-acceleration back to pre-COVID net additions for these more mature regions.

While I understand this isn’t the right way to look at it – because hits can come out of nowhere anytime – but the surprise success of “Squid Game” does make me wonder what subs/guidance would have been if it didn’t happen. That said, we will never know! And it really doesn’t matter because it did happen.

(We are also waiting on Season 4 release date of Stranger Things)

So just like last quarter and the quarter before that, we will look to 4Q21 as “critical” in driving investors’ long-term modeling/valuation assumptions. The difference in 4Q21, is that if trends don’t get better, it will force analysts to take down their 2022+ estimates. Until then, I still feel really good about our sub tracking capabilities.

The other/secondary issue here is that we are seeing a pickup in content amortization expense in 4Q21, that will result in operating margins decline to ~6.5% compared to ~14% in 4Q20. Management’s 4Q21 guidance of $500M came in below the Factset consensus of $794M on this. Given Q4 is a heavy content release schedule, especially for feature films that have faster amortization than series (and very expensive), it is not unusual to see margins come under pressure in Q4. Also, Netflix begins to amortize the $500M its paying for Seinfeld in 4Q21. In the long run, we expect content amortization expense to match cash content expense (Similar to other media companies). In the short run, a faster rate of growth in content amortization could be a source of downside risk to FY22 consensus margin estimates that are calling for another 250-300bps in operating margin expansion. However, if it translates to big subscriber gains, the market will look past it (which is why we say it is a secondary issue) – but if it doesn’t then we have a problem!

Call Takeaways / Thoughts

  • Getting toward to tail end of COVID choppiness, production delays and pull-forward of sub growth into 2020. <- Consistent with Nielsen Top 10 and our content production tracker
  • Churn down compared to comparable periods in both 2020 and 2019; “Retention very health” <- Consistent with SVOD/OTT survey results
  • Viewing per member “may be down slightly” compared to 3Q20, but up compared to 2019 comparable period. <- Consistent with back-to-school/office (in-person) and greater competition from other forms of entertainment (Sports/ratings up, Theatrical, shift back to OOH)
  • September saw an acceleration in growth <- Not surprising w/Squid Game and data acceleration; however, there is risk that this pickup in subs they are seeing to start the quarter as a result of “Squid Game” end up churning off by YE. We have seen it happen before!
  • Latin America growth was softer, “we took some price increases in Brazil” and “that tends to slow growth in the short-term, but we are already continuing to grow through it.”; makes reference to letter that Latam and UCAN more mature/more penetrated, but “still long runway for growth” and will be dependent on producing more local content. <- They are not ready to give up on sub growth in Latam/UCAN, but the way they talk about uncertainty in the long-term opportunity doesn’t inspire a ton of confidence. Latam likely more price sensitive and higher propensity to churn with multiple streaming services launching. Lack of sports rights for streaming could hurt Netflix competitively relative to Paramount+ and Star+ internationally. We are sure mobile-only plans driving greater mix of subs in EMEA/APAC, however, not showing up in ARPU likely due to price increases in developed areas of these regions.
  • Strength of content slate (English + Non-English), new + returning, high-profile film slate, and seasonal factors going into 8.5M guidance <- Agree that Q4 slate is full of films with “bankable” talent that should help drive faster sub growth and claw back share of engagement. However, it does seem they are relying on trends in prior Q4 periods to hold (and likely anchoring off consensus to some extent), which if they are facing market saturation issues then growth will ultimately disappoint. It will be important to see how the data trends rest of the quarter following “Squid Game”…. Again, NFLX has beaten Q4 guidance by an average of 1.67M since 4Q16 and 1.84M since 4Q18 – however, if management is basing their guidance off strong start to Q4 that ultimately slows later in November/December it will be a problem.
  • When asked about getting back to 27-28M annual sub edition level… “The big picture is no one’s really sure; you can’t come off the craziness of COVID and be confident in the next 2-years.” – “We are at 200M and something households, that’s pretty small compared to households ex-China, so there is plenty of room for growth. Streaming is developing at a great pace, all kinds of devices and competitors helping that market growing. Competition, obviously that’s a factor.” <- Management has no idea about long-term sub forecast, all they can look at is current quarter trends, promo schedule and content performance to get at the quarter guide; but a lot of uncertainty/risk to 2022+ still IMO.
  • No certainty that there is another “Squid Game” coming or if it does – when it will hit, but there large backlog of content. Highly-distributed and scalable content system. “Squid Game” commissioned by one of the leaders put in place in South Korea two years ago. <- The success of “Squid Game” wasn’t guaranteed, but just like a lot of hit content – you don’t know until after the fact. It is a hits driven business, and as we have said, largely a numbers game. The more content you produce, the greater the probability you find lightning in a bottle. Is this approach as efficient as Disney who has franchises they can leverage? No. But, for Netflix, they need to take more swings at bat because they lack franchise IP and have ambitions of creating content that appeals to everyone on earth.
  • Continue to focus on creating great content and benefit from secular growth in streaming; “but to Reed’s point, we can’t predict with certainty.”
  • Netflix is 9-years into original content strategy, but only a few years in film; feature production cycle can range from 2-5 years. <- We see this in the production data we track; a lack of movies is a growing reason for why users cancel their Netflix subscription. Increased competition from HBO Max and Disney+ likely a factor for this.
  • Netflix 3-5 year timeline for gaming; working on building internal development capabilities. “This is not just months, but years in the making. Years before it has a meaningful impact on the business. We are going to move quickly and learn quickly, but this is a multi-year build.” “Don’t expect us to go on a buying spree on Gaming.”

Before the call…

See below for preliminary breakdown of the Q. Overall, the quarter came in largely as expected. Q4 sub guidance of 8.5M reflects management’s confidence in Q4 content slate and strong QTD trends (NFLX has beaten Q4 guidance by an average of 1.67M since 4Q16 and 1.84M since 4Q18). Q3 subs came in ahead 4.4M vs 3.5M guidance, but UCAN and LATAM trends continue to be soft w/upside driven mostly by APAC – reinforcing concerns over market saturation and competition. We will see where numbers shake out post, but a return to 1.8 – 2.0M UCAN net adds a year in 2022+ still looks high to us. However, sub estimates aren’t going lower after this print – so we will leave those concerns for another day.

Netflix 3Q21 Earnings

(Financial Metrics are for 3Q21 unless otherwise noted)

  • 4.4M paid net adds (vs 3.5M paid guidance) <- Consistent with our forecast model of 3-5M, and slightly above our global paid net add estimate of 4.02M (3.52M International / 0.5M U.S)
  • 4Q21 guidance 8.5M global paid net additions (in-line consensus); vs. my expectation of 7M <- Reflects management’s confidence in Q4 content slate and strong QTD trends; NFLX has beaten Q4 guidance by an average of 1.67M since 4Q16 and 1.84M since 4Q18
  • Global paid subscribers +9% YoY 3Q21 (vs. 8.4% 2Q21 and +23% 3Q20)
  • Free cash flow negative $106M 3Q21, improvement relative to 2Q21 negative $175M; guiding 4Q21 FCF to be negative as production ramps back up and expects full year 2021 FCF to be “approximately breakeven – plus or minus several hundred million dollars depending on timing of production starts” versus YTD FCF of $410M.
  • “Anticipates being FCF positive on an annual basis in 2022 and beyond”
  • Repurchased 0.2M shares for $100M; slower buyback pace vs. 1M shares for $500M in 2Q21 - $5B authorization.
  • Revenue growth +9% subscriber growth +7% ARPU = Total 16% YoY (FX +200bps lift to ARPU; ex-FX +5%)
  • Regional Drivers
    • APAC largest paid membership growth contribution ~50% of total (2.2M paid net adds / up from 1.0M 2Q21) <- ARPU $9.60 and +2% YoY CC suggests constant mix of mobile-only vs. traditional plans; boost from “Squid Game” and above 3Q19 net adds of 1.54M
    • EMEA paid net adds ~41% of total (1.8M paid net adds / up from 188k in Q2) <- Lift from Middle East/Africa, still well below 3Q19 3.1M net adds and suggests limited growth developed Europe and less pronounced new subscriber impact from “Money Heist”
    • UCAN paid net adds ~2% of total  (73k paid net adds / up from 433k loss in Q2) <- Didn’t recapture lost subs from Q2; competition from Olympics + back-to-school + NFL season likely weighed on results… however, “Squid Game” didn’t hit the U.S. until very late in September – so we could be seeing more UCAN strength reflected in the guide than actual Q3 results.
    • LATAM paid net adds ~8% of total (330k paid net adds / down from 764k in Q2) <- Down from Q2 despite Money Heist = likely seeing impact from competition (Paramount+/HBO Max/Star+ launches); below 1.49M 3Q219 net adds.
    • UCAN/LATAM Management Commentary
      • “These regions have higher penetration of broadband homes although we believe we still have ample runway for growth as we continue to improve our service.”
  • Profit/Loss
    • FY21 operating margin 20% or “slightly better”; implies 4Q21 operating margin 6.5% (down from 14% in 4Q20) due to “backloaded big content release schedule”
  • Content Slate 3Q21 (Household viewer metrics based on 2-min reporting)
    • Biggest returning shows in the quarter
      • Money Heist – Season Five (69M households first four weeks / ~32% of paid subs); Compares to Money Heist Season 4 of 65M viewers / ~34% of subs; Money Heist Season 3 44M viewers / ~28% of subs.
      • Sex Education – Season Three (55M households first four weeks)
    • Limited Series
      • “Maid” launched on 10/1 – Expects to reach 67M households during first four weeks (vs. The Queen’s Gambit at 62M)
    • Squid Game
      • “Biggest TV show ever”
      • 142M member households have watched in first four weeks (Extraction / Bird Box… previous #1/#2 film spot 99M/89M… Surpassed Bridgerton Season 1 = #1 Series 82M)
      • #1 program in 94 countries (including the U.S.)
    • Film
      • “Sweet Girl” – Starring Jason Momoa - 68M member households first four weeks
      • “Kissing Booth 3” – 59M member households first four weeks
      • “Vivo” – Animated Family - 46M member households first four weeks
      • “Blood Red Sky” – German language horror – 53M member households first four weeks
    • Other
      • “Manifest” – 25M UCAN member households chose to watch in first 28-days, and Netflix ordered fourth and final season
  • Content Slate 4Q21
    • English series -> The Witcher, You, Tiger King and Cobra Kai
    • Non-English series -> Sintonia and final chapter of Money Heist
    • Movies
      • “Red Notice” (Dwayne Johnson, Gal Gadot and Ryan Reynolds)
      • “Don’t Look Up” (Leonardo DiCaprio, Jennifer Lawrence, Rob Morgan, Jonah Hill, Tyler Perry and Meryl Streep)
      • “The Harder They Fall” (Jonathan Majors, Zazie Beetz, LaKeith Stanfield, Regina King and Idris Elba)
      • “Army of Thieves” (Prequel to “Army of the Dead”)
      • “The Unforgivable” (Sandra Bullock, Viola Davis and Jon Bernthal)
  • Production Commentary
    • “Assuming no new COVID waves or unforeseen events that result in large scale production shutdowns, we currently anticipate a more normalized content slate in 2022, with a greater number of originals in 2022 vs. 2021 and a release schedule that is more balanced over the course of the year, as compared to 2021.” <- Consistent with our Production Tracker
  • Reporting Change
    • “Later in the year” shifting to reporting on hours viewed for titles rather than the number of accounts that choose to watch them <- Much better way of measuring performance and consistent with how Netflix measures ROI/Impact; Old method was household watching first 2-minutes.
    • Netflix will also start releasing title metrics more regularly outside of earnings <- Historically, criticized for lack of transparency; however, reporting hours viewed is better metric and household reach.
  • Other Content
    • Won most Emmys ever for a single network or service in a season of television (Netflix 44 vs CBS’ tally in 1974) <- Product delays due to COVID had greater impact on other media companies (and broadcast) because they don’t operate with as long of lead time compared to Netflix
    • Acquired “Roald Dahl Story Company” in 3Q21
  • Product
    • Free mobile plan launch in Kenya during 3Q21
      • “Hope it encourages more people to sign up for a paid membership”
    • Gaming
      • Acquired “Night School Studio” in gaming
      • “Gaming will be included in members subscriptions, will not have advertisements or in-app purchases.”
      • “We’ve begun testing our games offering in select countries. It remains very early days for this initiative and, like other content categories we’ve expended into, we plan to try different types of games, learn from our members and improve our game library.”
  • Marketing and Communications
    • “We also want our programming to be talked about and in the cultural zeitgeist”.
    • First global fan event “TUDUM” hosted in September 2021 incl. featured news, first looks and trailers from over 100 Netflix films/series NTM
    • TUDUM event trended at #2 spot globally on Twitter
    • TUDUM trailers/content following event were watched in over 180 countries, 700M views and more than 3B impressions in less than 4-days
  • Competition
    • Continues to call out all forms of attention-seeking activity as competition
    • “on October 4, when Facebook experienced a global outage for several hours, our engagement saw a 14% increase during this time period. ” <- Netflix experienced simliar boost when YouTube went down and they called it out in their 4Q18 investor letter ("When YouTube went down globally for a few minutes in October, our viewing and signups spiked for that time")

Top 10 Reporting Changes

Below table doesn’t include “Squid Game” because data as of 9/27/21 and is for only first 28-days and “Squid Game” released on 9/17.

Makes sense to see the largest impact of top 10 reporting change on “Series” given tonnage of series compared to film, and commitment required to watch an entire season versus just watching first two minutes. 

FLASHBACK | A Lot of Uncertainty & Risk For Netflix (NFLX) To 2022+ - Table1

FLASHBACK | A Lot of Uncertainty & Risk For Netflix (NFLX) To 2022+ - Table2