Netflix (NASDAQ:NFLX) introduced its standalone video streaming service in the U.S. in 2011, marking a significant shift from its earlier business model of offering streaming as an add-on service to DVDs. The company reported 21.7 million streaming subscribers in the U.S. at the end of 2011, and the figure increased to 27.1 million by the end of 2012.  The growth in streaming subscribers is being driven by the broader trends of media consumption over the Internet, increasing broadband penetration, higher download speeds and growth in connected devices. In addition, Netflix has leveraged its first mover advantage and good device reach to expand rapidly in the U.S. We expect the trend to continue and forecast Netflix’s U.S. streaming subscriber base to reach close to 45 million by the end of our forecast period.
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Increasing Broadband Penetration & Demand For Internet Media
At the end of 2011, Internet penetration in the U.S. stood close to 80% with around 245 million Internet users.  Internet penetration is on the rise and customers are dropping their DSL Internet and shifting to high speed broadband connections. This is the reason why AT&T (NYSE:T) has been losing DSL subscribers and cable companies such as Comcast (NASDAQ:CMCSA) and Time Warner Cable (NYSE:TWC) are adding more and more broadband subscribers every quarter. The growth in broadband subscriptions is one of the factors that will drive the demand for video consumption over the Internet. Netflix will continue to benefit from this trend as there is still room for broadband penetration to grow.
In addition, smartphone and tablet sales are growing rapidly. Laptops are getting slimmer with the growing popularity of ultrabooks and demand for traditional desktop computers is dropping. There is value for Netflix in this shift. Having multiple devices that are connected to the Internet, easy to use, mobile and sleek, perks up the appetite and desire for streaming video content. As a result, Netflix now constitutes almost 30% of the peak Internet traffic in the U.S. 
The growing demand from streaming is evident from the fact that almost all pay-TV companies are making efforts to complement their traditional pay-TV packages with streaming. For instance, Comcast has started its streaming service Xfinity Streampix, which is available to its subscribers for an additional charge of $4.99 per month. Time Warner Cable is offering a live TV streaming app and Dish Network (NASDAQ:DISH) acquired Blockbuster to enter the streaming arena. Amazon (NASDAQ:AMZN) and Verizon (NYSE:VZ) (in partnership with Redbox) are also offering their streaming services for low prices. The expected growth in the streaming industry is huge and Netflix will be a key beneficiary.
Netflix’s First Mover Advantage & Content Investment
Although competition is increasing, Netflix has the first mover advantage as it pioneered the subscription streaming service. The company started the service as an add-on feature to its regular DVD by-mail rental service. However, the customer response was tremendous and the number of streaming hours grew exponentially. This prompted Netflix to launch a standalone streaming service in the U.S. ahead of its competitors. The number of titles that Netflix currently offers far exceeds that of its competitors. Although Amazon has struck some important deals recently such as the one with Epix, its title count is still substantially lower than that for Netflix.  In addition, Netflix has been investing in original content along with striking some exclusive deals. The TV series such as House of Cards and Lilyhammer are examples of original and exclusive content on Netflix. The company also struck a deal recently with Disney (NYSE:DIS) under which it will get exclusive access to some of the latter’s content once the contract between Starz and Disney expires in 2015 (see What Are The Implications Of Netflix’s Deal With Disney?).
These efforts are leading to immense cost pressures on the company and as a result its content acquisition costs (as % of revenues) have skyrocketed from close to 21% in 2011 to more than 40% in 2012. However, these investments are necessary for subscriber growth to continue and Netflix’s margins should improve as the fixed content costs will be spread over a larger revenue base.
Using Telecom Industry As Benchmark
To understand Netflix’s growth potential, let’s look at the biggest subscription service in the U.S. – mobile. Almost everyone in the U.S. owns a mobile phone and the biggest players such as AT&T and Verizon have close to 98 million and 77 million retail subscribers, respectively. Verizon is the market leader with close to 32% share. Despite AT&T pioneering the mobile service in the U.S., Verizon rose to the top and AT&T could only manage to reach a market share of 25%.
Assuming that the broadband households approach the figure for total TV households in the U.S. over the long term, there could be close to 120 million broadband households by the end of our forecast period. A 32% share (similar to that of Verizon) will imply close to 40 million subscribers, which seems achievable for Netflix given that it already has close to 27 million U.S. streaming subscribers. To add to this, the company has a significant lead over its competitors and it wouldn’t be surprising if its subscriber base increases further to 45 million. Amazon, Dish, Comcast, Hulu and others have a lot to catch up on. Additionally, the streaming services may not be mutually exclusive choices for customers as is the case with mobile. A customer may subscribe to Netflix as well as Amazon if the additional expenditure is justified by the difference in the content of the two services.
The Significance Of U.S. Streaming Subscriber Growth
We estimate that Netflix’s U.S. streaming service constitutes close to 60% of its value. The number of U.S. streaming subscribers is one of the most critical business metrics for the company and has dictated its stock performance in the past.
Let’s take a brief look at how its future performance can influence the company’s value. If Netflix is able to maintain its lead and no competitor matches the depth of its content, the company may cross 55 million U.S. streaming subscribers by the end of our forecast period. Such a growth trajectory will imply close to 10-15% upside to our current price estimate. However, if the competition moderates the growth and Netflix’s subscriber growth stays flat at around 40 million, it would imply 5-10% downside to our current price estimate.
Overall, we remain positive about Netflix’s subscriber growth even though we believe that the market may be overvaluing the company. There are still cost concerns and Netflix’s business in the international markets remains unprofitable while its DVD subscriber base continues to decline steadily.
Our price estimate for Netflix stands at $127, implying a discount of about 30% to the market price.Notes: