For Netflix (NASDAQ:NFLX), 2012 was the year of recovery after the turmoil it faced in 2011 when certain management decisions such as price increase and re-branding of its DVD service (the decision was later reversed) led to sudden subscriber losses. Despite the recovery in subscriber additions, the stock didn’t gain a lot this year and that can be attributed to the continued losses faced due to international expansion. Netflix is justified in exploring new geographies given the worldwide adoption of the Internet and the first mover advantage that comes with it. However, the company is spending a big amount for the content it needs at hand to expand into these new markets.
2013 could see Netflix expanding into another undisclosed market, provided that the adoption of the service in Latin America and Europe remains on track. We expect to see continued cost pressure and increased competition domestically. Netflix is at a very delicate stage presently and could go either way depending on how the next few quarters play out. There is a remote chance that the company may even see a potential acquisition bid sometime next year, as indicated by some recent developments and speculations.
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Subscriber Recovery Continued But Growth Has Certainly Slowed Down
Although Netflix seems to have recovered from the slump, subscribers are not growing as quickly as earlier. During its Q3 2012 earnings release, the company lowered its domestic subscriber guidance for the full year from 7 million to 5 million. As per the company’s management, the reason behind this slowdown is its overestimation of market growth.  However, we believe that competition, especially from Amazon (NASDAQ:AMZN), is playing its part in slowing Netflix’s growth. In addition, growth is bound to slow down as Netflix’s subscriber base increases. As early adopters and streaming enthusiasts have already subscribed to these services, getting each incremental subscriber is going to be a slow and expensive task. It will take a better streaming catalog and more marketing on Netflix’s part to convince new subscribers to join.
DVD subscriber losses continued although most of them seem to be 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.
International Expansion Drove Content Costs Up
As per our estimates, Netflix’s content acquisition costs (as % of revenues) have skyrocketed from about 22% in 2011 to close to 44% in 2012. This was expected as the company needed plenty of content to make a compelling offering in new geographies that it expanded to. After its foray in Canada in 2010 and Latin America in 2011, Netflix expanded to the U.K., Ireland, Denmark, Norway, Sweden and Finland in 2012.
It has already crossed the 1 million subscriber mark in the U.K and Ireland and in general has witnessed good adoption. While expanding internationally makes sense from risk diversification and growth point of views, it has resulted in a short-term cost burden on Netflix. Given the fixed nature of content costs, Netflix has a highly leveraged business. International markets will become profitable only when Netflix reaches a sufficiently large subscriber base.
We believe that Netflix may launch in another international market next year as it has been aggressive with expansion lately and has witnessed good adoption in Latin America and Europe. However, this will lead to a continued pressure on margins which have suffered throughout 2012. We expect another soft year for Netflix in terms of profits, although an improvement is likely.
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) in 2012, 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 has grown 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 be a concern for Netflix.
In addition, while Comcast (NASDAQ:CMCSA) and Dish Network (NASDAQ:DISH) are nurturing their own streaming services, Verizon (NYSE:VZ) and Redbox have partnered 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 are charging less to customers. This could prove dangerous for Netflix.
We expect no respite from competition for Netflix and is only going to get tougher in 2013. The company’s best bet is to quickly make its international operations profitable, which can be a big boon to its stock, or get acquired by a cash rich giant.
Can Netflix Be Acquired In 2013?
Speculation around the potential acquisition of Netflix have been going around for a while, but Carl Icahn’s disclosure of his stake of roughly 10% in the company in late 2012 was an interesting development. Netflix adopted a ‘poison pill’ defense against its potential acquisition after billionaire investor Carl Icahn disclosed his stake and suggested that Netflix may be a good acquisition candidate.
The question that many are wondering is whether or not Netflix is better off being acquired by a cash rich tech giant? If so, who are the potential candidates? These include all of the big tech giants such as Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL), Comcast (NASDAQ:CMCSA), Google (NASDAQ:GOOG), Facebook (NASDAQ:FB) and others. But they may not really want to buy it.
Apple has typically been averse to acquisitions even with a lot of cash sitting around. Also, Apple has its hands full with multiple signature products, which are doing very well for so far, and the company has not really followed a subscription model that Netflix does. Microsoft may have a motive since having a well known service such as Netflix could help it promote its Windows 8 ecosystem with mobile users. However, that could only happen with certain exclusivity agreements and this would hurt Netflix. Netflix is available to everyone on a variety of devices, and it certainly doesn’t favor the customers if the device reach is limited.
There are other potential candidates as well such as Time Warner Cable (NYSE:TWC). Unless Netflix can fight off competition and quickly turn its international operations profitable, it may be better off sold.
It is hard to say whether any bid will emerge in 2013, but it won’t be surprising if it does. Netflix’s stock price has declined significantly from a peak of $300, and this might just be the time to acquire its assets and brand that could greatly complement a bigger company.
Our price estimate for Netflix stands at $81, implying a discount of about 10% to the market price.Notes: