Netflix Expands To Scandinavia But Margin Pressures Will Continue

Netflix (NASDAQ:NFLX) continues to diversify its business internationally as the U.S. market gets more competitive. The company has launched in Sweden, and it expects to launch in Norway, Denmark and Finland by the end of this week. ^[1] Netflix appears to have chosen the right markets as the consumer spending capacity and infrastructure make it conducive for the company to expand given the right content. However, as Netflix continues to pursue new markets, the higher upfront content costs will continue to keep its profits low or lead to some losses in the medium term.

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The Scandinavian countries of Norway, Sweden, Denmark and Finland have a combined population of a little under 25 million. Assuming 3 people per household, this gives a potential market of close to 8 to 9 million that Netflix will aim to capture. Given that competition exists from Amazon (NASDAQ:AMZN) and other local players, capturing 20% of the market will be a huge accomplishment. That gives the company close to 1.5 – 2 million potential subscribers.

A more optimistic scenario can lead to subscriber gains of close to 3 to 4 million over the long term. Other factors such as the colder weather, per capita income and broadband infrastructure will help Netflix’s service gain adoption.

The Scandinavian population has the capacity to spend on a service like Netflix. Moreover, due to harsh weather and cold climatic conditions, people tend to spend more time indoors, creating an incentive for the customers to subscribe to a movie service.

Additionally, the broadband penetration and speeds are perfect for the adoption. Sweden had close to 92.5% of its population using the Internet in 2010. ^[2] According to Akamai’s Q1 2012 report, Denmark and Finland were among the top 10 countries globally with highest broadband speeds. ^[3]

While expanding internationally makes sense, the margin pressure will continue unless Netflix can substantially increase its international subscriber base. We believe that most of Netflix’s content agreements are not based on revenue sharing and, thus, the company has decent amount of operating leverage. This implies that as the subscriber base grows, its margins will improve significantly. Until then, Netflix is taking a substantial risk.

Our price estimate for Netflix stands at $96, implying a premium of about 50% to the market price.

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1. Netflix Starts Nordic Service After Investing ’Heavily’ in Area, Bloomberg Businessweek, Oct 15 2012 [↩]
2. Internet World Stats [↩]
3. Q1 2012 State of The Internet Webinar, Akamai’s Official Website [↩]