Netflix Continues Subscriber Growth But Next Few Quarters Will Weigh On Profits

Netflix (NASDAQ:NFLX) recently released its Q2 2014 results. There was nothing surprising in the report and the previous trends persisted. The impact of seasonality was visible, but the company continued to gain subscribers both in the U.S. and international markets. It is worth noting that Netflix’s original series continue to gain traction and have been instrumental in driving its subscriber growth. For instance, the second season of Orange is the New Black has been critically acclaimed and saw a strong reception among Netflix’s customers. Going forward, Netflix will continue to invest in content and marketing to fuel its global expansion, which may weigh on the contribution margins temporarily. Let’s take a look at the key takeaways of second quarter earnings and long term risks that investors need to be aware of.

Our $315 price estimate for Netflix stands at a discount of about 30% to the market.

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Subscriber Additions Were Slightly Better Than Expected

Netflix had a slightly better than expected quarter in terms of net customer additions. The company gained 0.57 million domestic streaming subscribers compared to its initial expectation of 0.52 million. ^[1] However, there was a sharp sequential as well as a slight year-over-year decline in rate due to seasonality. Since Netflix does not report certain metrics such as the churn rate, it is difficult to assess whether this decline was primarily due to the higher impact of seasonality or a slowdown in gross subscriber additions. We believe that it was a combination of both as Netflix’s is likely to have cycled through majority of broadband houses in the U.S.

International operations did well as the company added 1.12 million net subscribers as compared to its expectation of 0.94 million. Netflix currently has more than 16.16 million international subscribers in Europe, Canada and Latin America. The impact of seasonality was less prominent here because of relatively small subscriber base and higher growth momentum.

International Expansion To Remain In Focus For Next Two Quarters

Going forward, Netflix’s international expansion could have a significant impact on both its subscriber additions as well as contribution margins. In September 2014, it will launch its service in Germany, France, Austria, Switzerland, Belgium, and Luxembourg. This expansion could push its quarterly net additions to as high as 2 million, but would lead to a negative impact on profits in the short term. However, given that Netflix’s current international operations are nearing profitability, it makes sense for the company to take some risk and consolidate its position in the international market.

Given that Netflix has established its presence in the U.K., Ireland and Nordic countries, it is natural for the company to expand into other regions of Western Europe which offer the best growth potential. A common theme across these markets is high internet penetration and fast broadband speeds. The table above shows the total addressable market for Netflix. The combined population of these countries stood at 175.7 million at the end of 2012, with the total number of internet users exceeding 141 million. Assuming roughly 2.65 persons per household (a figure similar to that for the U.S. in 2010), Netflix’s addressable market stands at nearly 54 million potential subscribers. If the company can get to 30% of these households in the long run, it could earn incremental revenues of roughly $1.75 billion annually. A significant portion of this is already incorporated in our forecasts for international subscribers.

However, margins are likely to shrink as a result of this move due to additional content spending.

Long Term Risks To Consider

Netflix’s content obligations continue to increase but its ability to fulfill them is also growing. There are two main risks that the company faces in the long run. First, if the subscriber base flattens out, Netflix will need to spend additional amount on content in order to retain its customers while not having enough room to grow its revenues. This could happen due to market saturation or competitors catching up. In such a scenario, the only option left for Netflix will be to raise its prices which may not resonate well with customers. Second, the broadband interconnection fees could increase in future thus putting pressure on Netflix’s margins. The company has been vocal about the importance of net neutrality and the possibility that broadband providers could extract more money out of content providers for using their pipes.

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1. Netflix’s Q2 2014 Letter To Shareholders [↩]