Recap

During Week 20, we analyzed the streaming business model followed by Netflix. With a strong customer base from it's DVD era & their existing subscription business model, Netflix was in a perfect position to ride the streaming era.

Netflix streaming business model is built around subscription based streaming. This is complemented by ad supported revenue for certain subscription tiers. There are multiple subscription tiers in line with customer segmentation & usage.

We then went through individual unit economics & arrived at the CAC / LTV ratio of approx. ~0.30 which means Netflix invests USD 0.30 to generate USD 1 of gross margin per customer which is highly efficient.

We can look at numbers & be impressed at it's highly efficient unit economics. As finance professionals, we take time to look at the data, analyze & present numbers. But what decisions drive these numbers? What is the story behind these numbers? Let's explore

The Underlying Drivers

The mechanics of unit economics is simple -

If the unit is a "customer", A company spends money on acquiring customers who provide revenue over the lifetime of the customer. So,

1. The cost of acquiring a customer must be less than the lifetime revenue generated / expected to be generated from that customer. The pricing must be right to ensure customer satisfaction for the services rendered.
2. The lifetime of the customer must be long enough to ensure the company makes positive returns on that customer which means the churn rate must be minimal or in other words, customers need to be retained for the longest period.

If the unit is a "product,

1. The revenue generated from the product must be higher than the variable costs of producing that product. The pricing must be right to ensure customer satisfaction for the product.
2. The contribution margin generated from all the sales must cover the fixed costs. This means scale is critical to ensure profitability

In both the above cases, the customer must be happy with the product or service at the price at which it is sold.

I know this is Finance Byte & not Strategy Byte. But the below definition of Strategy from Roger L Martin shows the importance of customer satisfaction to a company's strategy.

Strategy is an integrated set of choices that compels desired customer action

Very simple & straightforward. Thus, companies must make an integrated set of choices to compel the customer to take action desirable to the company - meaning customers must buy the company's products at sufficiently high prices for a sufficient period of time for the company to earn attractive returns.So, with the above in mind, let us understand what choices Netflix made to ensure attractive & efficient unit economics.

The Fork

There are two sides of the unit economics equation

1. The Customer Side - which involves revenue, margin, profit etc "per" customer or product &
2. The Cost Side - which involves the cost incurred "per" customer or product to derive that revenue.

So, let us take this discussion into two forked roads:

Fork 1 - Customer Side

What did Netflix do to ensure customer satisfaction & happiness which in turn drives their unit economics?

1) Prioritize Original Content

After initially licensing content from other studios, Netflix started investing heavily in original content. In 2023, it spent approximately USD 17 - 18 million on content. (Source : here)

The reason is it creates a competitive moat. It is basically investing in it's own content thus reducing dependency on expensive licensing fees from traditional studios who have themselves launches online streaming platforms like Disney, HBO etc. Also, the quality of original content determines customer preferences for traditional shows vs. Netflix originals.

But, what is a moat?

An Economic moat is a durable economic competitive advantage that enables a company to be profitable long-term. Economic moats include the complexity of the product, high switching costs & brand value. (Source : here)

By investing in original content, Netflix is creating a moat of intellectual property. But how is it helping the numbers?

As per Nasdaq (Source : here),

"These strategic content investments aim to maintain Netflix's competitive edge in an increasingly crowded streaming landscape. The company's fourth quarter 2024 results show that this strategy is working, as revenue increased 16% year over year & operating income rose 52%."

2) Improve customer experience

Netflix expanded from series & movies to live events like sports, entertainment events, gaming & AI driven personalized recommendations. This ensures customers stick with Netflix reducing churn & extending the average lifespan of each customer with the company which in turn increases LTV.

The goal of Netflix's recommendation engine is to ensure that customers get to see the content they are interested in. They have all that data related to customer preferences. They keep customers hooked on by :

1. Binge watching - If you've noticed, once an episode ends, the next episode or season starts without any action from the user. This ensures the user watches all the episodes of a series without any interruption.
2. Once a series is complete, the recommendation engine provides options for the next series for the customer to select & watch based on their preferences.

3) Localized Content

Netflix tailors content for local audiences & tastes, maximizing customer retention in all regions where it streams.

4) Tiered Pricing

1. Netflix optimizes pricing by market or geography depending on local purchasing power, content library & competitive landscape.
2. Introduction of ad-supported tiers attract new customers who are cost sensitive & creates a new revenue stream. The ad-supported tier now reaches over 190 million global monthly active users. In Q2-2025 alone, advertising revenue reached a substantial USD 3.2 billion. (Source : here)

Fork 2 - Cost Side

1) Relentless Focus on Cost Efficiency

Netflix uses proprietary dashboards & analytics to allocate cloud costs, track infrastructure spending & optimize engineering resources.

These dashboards are also visible to engineers which fosters cost discipline across the organization.

For e.g., Netflix manages to

1. Report AWS (Amazon Web Services) billing data in a context that makes sense
2. Use a custom dashboard to relay cost context to each team
3. Improve data cost visibility by pushing relevant information to key decision makers. (Source : here)

2) Account sharing crackdown

Netflix clamped down on ‘password sharing’ in subscriptions as it wants to limit the number of devices people can use to access their service. This crackdown on password sharing in 2023 represented an attempt to convert an estimated 100+ million non-paying households into revenue-generating customers.

Impact on Financials

The impact of the above actions related to positive unit economics when rolled up to the entire customer base along with other strategic initiatives resulted in an extraordinary result in their financial & operating performance:

Netflix's financial performance underscores the strength of its content strategy. The company finished 2024 with 302 million memberships, adding 19 million paid subscribers in the fourth quarter alone—the biggest quarter of net additions in its history. Revenues grew to $10.25 billion in fourth-quarter 2024, with operating income reaching $2.27 billion. (Source : here)

Below are the key financial extracts from their Q2 2025 shareholder letter:

Operating Margins

1. In Q2, we grew revenue 16% and our operating margin of 34% expanded seven points year over year.
2. Year-over-year revenue growth was primarily a function of more members, higher subscription pricing and increased ad revenue.
3. All regions experienced healthy year-over-year revenue growth, with each region posting double-digit F/X neutral increases.
4. Member growth was ahead of our forecast, although this occurred late in the quarter, limiting the impact on Q2 revenue. Operating income totaled $3.8B, up 45% year over year, and operating margin was 34% vs 27% in Q2’24.
5. Both operating income and operating margin were slightly ahead of our forecast given the revenue upside in the quarter and timing of expense spending.
6. Diluted EPS amounted to $7.19 vs. $4.88 last year (+47% year over year).

Cash Flow

1. Net cash generated from operating activities in Q2 was $2.4B vs. $1.3B in the prior year period. Free cash flow in Q2’25 totaled $2.3B vs. $1.2B in Q2’24. We are increasing our full year 2025 free cash flow 5 forecast to $8B-$8.5B from approximately $8B due to the increase in our revenue and operating margin forecast.
2. During the quarter, we paid down $1.0B of USD and EUR senior notes using proceeds from our 2024 refinancing, and we repurchased 1.5M shares for $1.6B. We have $12.0B remaining under our existing share repurchase authorization.

With this, we complete the unit economics series & will move on to the next topic.