Netflix Continues To Benefit From Content Superiority

Netflix‘s (NASDAQ:NFLX) stock jumped by 7% in after-hours trading following its Q1 2014 earnings announcement. The growth in the number of subscribers in both the U.S. and international markets was impressive. This was primarily driven by reduced subscriber churn and popularity of its original content. Netflix intends to double its investment in original TV series this year, but the spending will still remain less than 10% of its overall content expenses. Subscriber growth led to improved domestic margins and a reduction of losses in international operations. We expect this trend to continue although the rate of margin improvement is likely to come down. The company also announced that it may consider increasing prices for new customers by $1 to $2 in the latter half of 2014. We believe that the immediate impact of this price increase will be minimal and any additional profits will be directed towards funding overseas expansion. Here is what you need to know about Netflix’s earnings.

Our $271 price estimate stands at a discount of about 25% to the market.

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Subscriber Growth Is Benefiting From Higher Customer Satisfaction And Content Leadership

Netflix gained 2.25 million domestic streaming subscribers in the first quarter of 2014, which was inline with its earlier guidance. This was accompanied by 25% growth (year over year) in revenues and a sequential improvement of approximately 150 basis points in contribution margins. ^[1] On the international front, the company added 1.75 million new subscribers, which was substantially higher than the figure for Q1 2013. ^[1] What’s interesting is that international quarterly additions are gradually approaching those for the U.S. and the company eventually expects its international business to overshadow its domestic business. International losses have come down a great deal and Netflix expects to become profitable in its ‘current’ international territories this year.

Netflix’s content leadership and improving customer satisfaction have been the primary reasons behind its continued growth. Given the company’s statements during its recent earnings announcement, we deduce that the churn levels may have come down. Therefore, net additions are being fueled by a lower number of disconnects rather than the strength in gross subscriber additions. That’s positive news for the company but also signals a maturing business. In addition to this, Netflix’s focus on bringing original content has paid off. The season 2 of House of Cards was a big hit and more original content is lined up for this summer. This will help the company mitigate the slowdown in subscriber growth due to seasonality and offset the impact of the upcoming soccer world cup. Netflix is also trying to reduce the window of delay in terms of syndicating its original content in international markets and has made its original episodes available as early as 1 week or 24 hours after they were released in the the U.S.

Contribution Margin Growth May Slow Down Going Forward

While the first quarter saw a significant increase in contribution margin both in the U.S. and international markets, the rate of increase will slow down. With less room available for growth, Netflix will fall behind its target of increasing domestic margins by 400 basis points every year. We have incorporated this expectation in our forecast. Additionally, the company intends to expand to more overseas markets in the second half of 2014. While it expects to become profitable in its ‘current’ international territories, further expansion will keep the overall international segment in losses. But that’s not necessarily bad. It might put pressure on earnings in the short run, but improved profitability in the U.S. is generating enough funds to fuel overseas expansion. In fact, the company has just $900 million in debt compared to $1.67 billion in cash lying in its coffers. It is an opportune time for Netflix to enhance its presence in international markets. This will put the firm in a unique position to benefit from the growth in Internet usage, broadband speeds and mobile devices in emerging markets. Currently Netflix only caters to emerging markets of Latin America and rest of its international operations are confined to developed economies of Canada and Western Europe.

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1. Netflix’s SEC Filings [↩] [↩]