Original Content Remains The Key Factor To Netflix’s Value

by Trefis Team
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Trefis
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Netflix
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Quick Take

  • Netflix’s stock was down 6% in after-hours trading as the company fell short of analysts’ expectations
  • However, the results still came within the guidance range as Netflix saw significant growth in its international business and the continued success of original programming drove subscriber growth in the U.S.
  • The company reiterated its focus on original programming and will continue to invest heavily in content
  • However, we remain wary of the possible slowdown in Netflix’s growth in the U.S. as well as its rising content obligations

Netflix’s (NASDAQ:NFLX) stock was down 6% in the after-hours trading session as the company’s Q2 2013 earnings fell short of analysts’ expectations. However, the net U.S. subscriber additions were up from the second quarter of last year reflecting mixed impact of seasonality and success of Netflix’s original series Arrested Development.

In addition to this, Netflix seems to be managing its costs (on its income statement) well and appears to be on track to increase its U.S. streaming contribution margins by 400 basis points in 2013. However, if we look at its performance for the first half of 2013, we note that the operating cash flow has declined compared to the same period a year ago, indicating some steep upfront content payments that still haven’t made their way to the income statement. [1] We remain doubtful about the company’s ability to continue adding original content while maintaining the current subscription pricing.

Netflix’s international business did well, adding 610,000 net subscribers and reducing contribution losses both sequentially as well as compared to the second quarter of last year. [1] The company expects to gain roughly 900,000 net subscribers in the third quarter as it launches in Netherlands and continues to expand in current markets. However, the contribution losses are likely to increase due to higher content spending.

See our complete analysis for Netflix


Netflix Reiterates Its Focus On Original Content

Netflix stated that its content advantage and launch of Arrested Development helped offset the negative impact of seasonality in the second quarter. [2] The company has been adding original and exclusive programming to its streaming library, which seems to be paying off. TV series such as House of Cards, Lilyhammer, Hemlock Grove, Orange is the New Black and Arrested Development are drawing lot of audience and attracting customers to sign up. In fact, Netflix has effectively marketed these exclusive shows to maintain its subscriber momentum.

The company has ordered the 2nd seasons of all first season projects, which is an encouraging sign and reflects the popularity of its original series among its customers. The quality of the programming is good, which is evident from that fact that Netflix’s original series were nominated for 14 Emmy awards, with most of those nominations coming from House of Cards. ((ref:3)) Next year, the company plans to premiere 2nd season of House of Cards, Hemlock Grove, and Orange is the New Black, and debut Sense 8 and several kids-focused original programs. [2]

We Remain Cautious About Possible Slowdown In The U.S. & Rising Content Costs

The 2nd quarter saw a steep sequential decline in net U.S. streaming subscriber additions due to seasonality. The company expected the figure to decline compared to Q2 2012 as well, but the launch of Arrested Development towards the end of May temporarily fueled gross subscriber additions. [2] In the third quarter, Netflix expects to gain roughly 1.09 million net subscribers (mid-point of guidance) which is slightly lower than the figure for Q3 2012. [3] These facts suggest that Netflix has gotten big enough in the U.S. and might start to witness some slowdown in its growth. This is a cause of concern as U.S. streaming business constitutes roughly 60% of the company’s value according to our estimates. It is the profitability of this business that has armed Netflix with enough capital to invest in international expansion without raising much debt.

Additionally, Netflix’s streaming content obligations have grown in the last few quarters. The figure stood at $4.97 billion in Q3 2012 and increased to $5.67 billion by Q1 2013. [1] Although the trend is not disturbing and the growth is not as steep as what we saw in 2011 and 2012, it is the growing competition that’s a cause of concern. Amazon (NASDAQ:AMZN) and Hulu are making significant content investments which can make it very expensive for Netflix to acquire new programming. Amazon is spending $1 billion in licensing content and Hulu has received $750 million from its parent companies to improve its streaming content library. [2] The influx of all this cash could push the prices up.

Our price estimate for Netflix stands at $171, implying a discount of about 30% to the market.

Understand How a Company’s Products Impact its Stock Price at Trefis

2009

2010

2011

2012

Streaming Content Costs as % of Revenue

3%

7%

22%

44%

Total Content Costs as % of Revenue

13%

14%

25%

46%

Streaming Content Obligations as % of Revenue

60%

122%

156%

Total Streaming Content Obligations ($ Million)

1,299

3,907

5,634

Notes:
  1. Netflix’s SEC Filings [] [] []
  2. Netflix’s Q2 2013 Earnings Transcript [] [] [] []
  3. Netflix’s Q2 2013 Letter to Shareholders []
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