What 2014 Holds For Netflix

The year 2013 has been a stellar one for Netflix (NASDAQ:NFLX) as the company’s stock gained roughly 300% on the back of strong streaming subscriber growth in both domestic and international markets. The investment in original content is paying off as well, and Netflix is now attempting to partner with pay-TV companies to strengthen its distribution and marketing capabilities. Although we do not expect a similar growth from Netflix’s business in the new year, the company will continue to spend on original content and stabilize its business overseas. Here is what the new year holds for the streaming video giant.

Our price estimate for Netflix stands at $232, implying a discount of about 35% to the market price.

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Expect More Original Content

Given the success Netflix saw in 2013 from its investment in original content, and some of the deals it signed in late 2013, we can expect the company to bring more exclusive TV shows and movies in 2014, despite rising content obligations.

The launch of Arrested Development helped offset the negative impact of seasonality in the second quarter. Additionally, TV series such as House of Cards, Lilyhammer, Hemlock Grove and Orange is the New Black, drew large audiences and attracted customers to sign up. Netflix has been effectively marketing these exclusive shows to maintain its subscriber momentum. Next year, the company plans to premiere a second season of House of Cards, Hemlock Grove, and Orange is the New Black, and debut Sense 8 and several kids-focused original programs. In December, it struck a deal with Sony to bring Better Call Saul, which is a Breaking Bad spin off, exclusively to its subscribers. Dreamworks Animation is working on bringing its first original series on Netflix. Although the subscribers can expect a lot more fresh content going in to the new year, it will come at a steep cost.

Netflix’s streaming content obligations have grown notably in the last few quarters. The figure stood at $4.97 billion in Q3 2012 and increased to $5.67 billion by Q1 2013. It jumped to $6.37 billion by Q2 2013, growing further up to $6.50 billion by the end of the third quarter. That’s roughly 1.5 times the revenues that the company is expected to earn in 2013. This is certainly a cause of concern, but it isn’t something that has deterred Netflix from acquiring expensive original content in the past.

Domestic Stream Subscriber Growth Is Likely To Slowdown

Netflix intends to expand its domestic streaming contribution margin by 400 basis points annually. That will only work if it is able to maintain a rate of 6 million net domestic subscriber additions every year. It seems to be a long shot given that by the end of this year, Netflix will cover close to one-third of U.S. households and its growth is bound to slow down with this increasing penetration. Looking at the numbers suggests that although the company maintained strong growth in its domestic streaming subscriber base, the growth rate has come down slightly. The trailing twelve month growth rate has gradually declined from its peak of 25.6% in Q4 2012 to 23.9% in Q3 2013, and we expect this trend to continue. The level of content investment required to maintain this growth may not be economically justifiable, given that Netflix’s content obligations have increased substantially over the past few years.

Significant Jump In International Profitability

We expect notable improvement in Netflix’s profitability in international markets. In other words, the contribution loss is likely to come down substantially as the company’s costs get spread across a wider revenue base. This will primarily result from subscriber growth in Europe, Canada and Latin America, as Netflix doesn’t have any plans to raise prices anytime soon. In 2012, the international contribution loss averaged roughly $97.29 million per quarter. During the first nine months of 2013, the quarterly average came down to $72.35 million and we expect this trend to continue. The customer response, especially in Europe and Canada, has been good and Netflix has grabbed some critical deals to ensure its subscriber growth. For instance, the company bagged a deal in the U.K. in September, partnering with Virgin Media, which is now offering Netflix’s service to its pay-TV subscribers. This could pave the way for more such deals and give a strong boost to Netflix’s business in Europe.

Our price estimate for Netflix stands at $232, implying a discount of about 35% to the market price.

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