When Netflix’s (NASDAQ:NFLX) stock fell in the after-hours trading after the company disappointed with its Q3 2012 results, no one thought that it would bounce back by 40% over the next 1.5 months. At that time, we updated our price estimate to $81, indicating significant upside potential as we felt the market had punished Netflix’s shares a bit harshly. Profits were definitely being squeezed in the short term, but Netflix’s content and brand advantage were being underestimated.
With the disclosure that investor Carl Icahn’s firm took a 10% stake in Netflix and the company’s recent exclusive deal for Disney’s movies where it beat out some larger pay-TV networks, the stock has soared.
Our price estimate now stands at a discount of about 5% to the market price, indicating that Netflix may not have much room to grow from here unless it significantly changes the way it pays for its content or gets acquired by a company with deeper pockets. Although we do believe that subscriber growth will continue both in the U.S. and international markets, there are certain risks that may impact Netflix’s profitability. Below are some of the key issues we feel are critical to Netflix’s future.
Subscriber Growth Slowing Down In The U.S. – How Much Can Netflix Grow?
Netflix enjoyed high subscriber growth until mid-2011. The company revolutionized the movie rental industry when instead of having to drive down to a rental store, customers could get DVDs right at their homes without having to pay for postage. This proved to be a significant advantage as Netflix grew its subscriber base from 1.5 million in 2003 to close to 12.3 million in 2009.  In 2009, the explosive growth began and Netflix expanded its base from 12.3 million to 24.4 million subscribers within a span of two years. The reason for this growth was a significant push into streaming, which was initially added as a free add-on service for DVD subscribers and later became Netflix’s mainstream offering.
However, following its decision to increase the prices of hybrid plans by 60% in 2011, Netflix’s subscriber growth trajectory changed. The company lost subscribers in Q3 2011 for the first time in years, which sent the stock plunging.
Although Netflix seems to have recovered from that slump, subscribers are not growing as quickly as they did before. During its Q3 2012 earnings release, the company lowered its domestic subscriber guidance for the full year from 7 million to 5 million. DVD subscriber losses continue although most of them are converting into streaming-only subscribers. While we expect Netflix’s U.S. streaming subscribers to increase from 22 million in 2011 to close to 40 million by the end of our forecast period, we expect DVD subscribers to decline from 11 million to 5 million during the same period. It must be noted that DVD rental is a higher margin business compared to online streaming.
We have incorporated these expectations into our pricing model and believe that higher growth in the U.S. is unlikely given the increasing competition.
First Mover Advantage Is There, But Competition Is Growing
There is no doubt that Netflix still has the content advantage over its competitors and the closest match perhaps would be Amazon, which is still far behind. Besides its regular deals, Netflix is also spending a notable portion of its content budget on original programming. The company furthered its content advantage with a landmark deal with Disney (NYSE:DIS) recently, where it grabbed exclusive rights for Disney’s newly released movies. Netflix will make them available to its subscribers as soon as 7 months after their theatrical release. Amazon doesn’t have such deals, and Netflix actually snatched this contract from Starz, which is a premium pay-TV network. The company’s commitment towards content improvement is commendable, but that comes with high costs.
Netflix’s first mover advantage has brought it this far, but competition is growing from big giants. Amazon offers streaming bundled with its Amazon prime service. According to Bloomberg, Amazon Prime had between 3 million and 5 million subscribers in October 2011 and was planning to increase this count to 7 to 10 million subscribers by the end of 2012 or mid of 2013. Amazon had over 22,000 titles in its streaming library in August 2012, representing 70% growth in 2012 alone.  The company further signed a deal with Epix in September to add 3,000 more titles to its library, bringing the total count to 25,000. It appears that Amazon Prime’s subscriber base and content growth is sufficiently large to cause concern for Netflix.
In addition to this, while Comcast (NASDAQ:CMCSA) and Dish Network (NASDAQ:DISH) are nurturing their own streaming services, Verizon (NYSE:VZ) and Redbox are partnering to launch Redbox Instant. What’s surprising is that almost all of these services are priced lower than that of Netflix. These big giants are using streaming as a way to promote their primary business and hence are charging less to customers. This could prove dangerous for Netflix.
Content Costs Are The Biggest Concern
Netflix’s content acquisition costs (as % of revenues) have increased from 14% in 2010 to an estimated 44% in 2012. This huge jump can be attributed to Netflix’s international expansion as well as its foray into original programming. However, we cannot deny that Netflix will need to continuously improve its content given that customers may be willing to end their subscriptions once they have cycled through it. While making the entire content available at once to subscribers is an advantage, it also poses a challenge for Netflix in terms of keeping subscribers interested. We expect content costs to increase further in the future and put pressure on Netflix’s margins. Even though content obligations have stabilized in the past two quarters, the recent expensive deal with Disney suggests that they could increase further (see What Are The Implications Of Netflix’s Deal With Disney?)
International Growth Provides Support
Not all is gloomy for Netflix. The company has been aggressive with its international expansion. Following its debut in Canada, it has expanded to Latin America, The U.K., Ireland, Norway, Denmark, Finland and Sweden. Netflix had already gained more than 4 million subscribers internationally by the end of Q3 2012. Latin America has been little slow primarily due to payment issues as many people don’t have credit cards and several debit cards are not approved for online transactions. However, this issue should resolve slowly and the market is still lucrative from a long-term perspective. Netflix has spent a lot upfront in getting content deals tailored to these international markets. While this is resulting in near-term losses, subscriber growth will lead to profits due to the fixed nature of Netflix’s content costs. Over the long term, international markets have the potential boost Netflix’s cash flow growth provided the company can acquire enough subscribers.
Our price estimate for Netflix stands at $81, implying a discount of little over 5% to the market price.Notes: