Growth at Netflix Comes at a Cost

Note: this blog is published by Jan Dawson, Founder and Chief Analyst at Jackdaw Research. Jackdaw Research provides research, analysis, and consulting on the consumer technology market, and works with some of the largest consumer technology companies in the world. We offer data sets on the US wireless and pay TV markets, analysis of major players in the industry, and custom consulting work ranging from hour-long phone calls to weeks-long projects. For more on Jackdaw Research and its services, please visit our website.

Netflix reported its financial results on Monday afternoon, and the market loved what it saw – the share price was up 20% a couple of hours later. The single biggest driver of that positive reaction was subscriber growth, which rebounded a little from last quarter’s pretty meager numbers. Here are a few key charts and figures from this quarter’s results. A much larger set can be found in the Q3 Netflix deck from the Jackdaw Research Quarterly Decks Service, which was sent to subscribers earlier this afternoon. The Q2 version is available for free on Slideshare.

Subscriber growth rebounds

As I mentioned, subscriber growth rebounded at least a little in Q3. However, the rebound was fairly modest, and the longer-term trends are worth looking at too. Here’s quarterly growth:

Quarter on Quarter growth Netflix Q3 2016

The numbers were clearly better than Q2 both domestically and internationally, but not enormously so, especially in the US. Here’s the longer-term picture, which shows year on year growth:

Year on Year Growth Netflix Q3 2016

As you can see, there’s been a real tapering off in the US over the past two years, while internationally it’s flattened following consistent acceleration through the end of last year. To put this year’s numbers so far in context, here’s a different way of presenting the quarterly domestic data:

Cyclical Growth Trends Netflix Q3 2016

That light blue line is the 2016 numbers, and as you can see each of this year’s quarters has been below the last three years’ equivalents, and the last two quarters have been well below. Arguably, Q3 was even further off the pace than Q2, so for all the celebration of a return to slightly stronger growth, this isn’t necessarily such a positive trend when looked at this way.

The cost of growth

Perhaps more importantly, this growth is becoming increasingly expensive in terms of marketing. I’ve mentioned previously that, as Netflix approaches saturation in the US, it will need to work harder and spend more to achieve growth, and we’re still seeing that play out. If the objective of marketing is growth, then one way of thinking about marketing spending is how much growth it achieves.

Ideally, we’d measure this by establishing a cost per gross subscriber addition – i.e. the marketing spend divided by the number of new subscribers enticed to the service as a result of it. However, since Netflix stopped reporting gross adds in 2012, we have to go with the next best thing, which is marketing spend per net subscriber addition, which is shown in the chart below:


As you can see, there was a massive spike in Q2 due to the anemic growth numbers domestically, but even in Q3 the number is around 3 times what it had been in the recent past. Yes, Netflix returned to healthier growth in Q3, but it had to spend a lot to get there. But even in the international line, somewhat dwarfed by US spending the last two quarters, there has been an increase. In its shareholder letter, Netflix wrote this off as increased marketing for new originals, but the reality is that the marketing was still necessary to drive the subscriber growth it saw in the quarter, which in turn was lower than it has been.

The price increase worked – kind of

Of course, one big reason for the slower growth these last two quarters is the price increase Netflix has been introducing in a graduated fashion – or, in its own characterization, “un-grandfathering” of the base which was kept on older pricing for longer than new subscribers. As I wrote in this column for Variety, the price increase was really about keeping the margin growth going in the domestic business as Netflix invests more heavily in content, and I predicted that it would pay off in the long term.

Here’s what’s happened to the average revenue per paying customer as that price increase has kicked in:

Revenue per subscriber Netflix Q3 2016

There’s an enormous spike domestically in Q3, whereas internationally the increase kicked in a little earlier, despite the fact that it only affected certain markets. Overall, though, the price increase has driven average revenue per subscriber quite a bit higher – around $2 so far – so it’s arguably worked. Of course, it’s come at the cost of increased churn and perhaps slower customer additions, and the longer term effects of that will take a while to play out. We’ll need to watch the Q4 results to see whether growth starts to recover, or whether the results we’ve seen over the last two quarters are a sort of “new normal” we should expect to see more of going forward.

Meanwhile, domestic margins continue to tick up in a very predictable fashion:

Netflix Q3 2016 Domestic margins

The key, though, at this point, is to marry this increasingly profitability with breakeven followed by increasing profitability overseas, something Netflix has been predicting will happen next year. As of right now, the international business as a whole is still unprofitable, but several individual countries outside the US are already profitable for Netflix, and so it has a roadmap for other markets as they grow and hit scale milestones as well. What investors buying the stock today are really betting on is that this scenario plays out as Netflix expects it to, but it’s arguably still too early to tell whether it will.