Netflix’s Outlook on Subscriber Growth and Spending

Netflix’s (NASDAQ:NFLX) selling, general and administrative (SG&A) costs as a percentage of gross profits have fallen from around 70% of gross profits in 2006 to around 49% in 2009. ^[1] We expect this ratio to drop further as Netflix as subscriber growth has outpaced marketing costs in recent quarters.

Netflix competes with cable and satellite operators like Time Warner Cable (NYSE:TWC) Comcast (NASDAQ:CMCSA), Dish Network (NASDAQ:DISH) and DirecTV (NASDAQ:DTV) for streaming and pay-TV services, and video rental services like Redbox in its traditional rental delivery business.

While our current price estimate is well below the market price, continued improvements in cost controls and subscriber growth lead to a more sanguine picture than our current forecast suggests.

Subscribers and SG&A the Key Drivers

In the past we believed that the Netflix SG&A to gross profit ratio was falling due to the company gaining traction with customers given its differentiated product offering. We believed this reduced the need to engage in aggressive marketing campaigns.

However as we noted in a recent Trefis article, marketing costs rose 39% in the latest quarter and subscriptions jumped.

This recent information might offer some fresh light to our analysis.

1) Netflix might have stepped up its marketing efforts recently to compete with cable companies and satellite operators that offer streaming services and pay-TV services. This is a small but growing portion of Netflix’s business.

2) As sales and the subscriber base have increased, marketing expenses (which account for 80% of SG&A in the most recent quarter) could drop proportionally looking ahead. Gross subscribers jumped by 88% in the last quarter on a year over basis. ^[2] See the sensitivity of growth in the subscriber base in this chart.

3) We currently expect SG&A to gross profits to drop to 44% over the forecast period while Trefis member forecasts expect it to drop lower to around 41%, adding 7% upside to our price estimate included below

4) Large drops in marketing expenses or SG&A lead to big moves in our forecast and could significantly impact our price estimates.

While we realize our baseline estimates are pessimistic, we highlight there are several triggers that might force us to reevaluate our stance.  Subscriber growth and SG&A spending are two highly sensitive drivers that add significant changes to company value by our estimates.

Our complete analysis for Netflix’s stock is here.

1. Netflix reports SG&A expenses and gross profits in its SEC filings. [↩]
2. See recent 3Q 10-Q [↩]