Netflix Sinks On Subscriber Growth Decline, Is The Market Saturating?

Netflix’s (NASDAQ:NFLX) shares fell significantly following the company’s Q3 2014 earnings announcement. Even though the revenues were more or less in-line with the expectations, domestic streaming subscriber additions fell significantly short of the company’s guidance. The massive sell-off was not surprising, considering that Netfix’s stock has traded mostly on its subscriber growth. It is important to assess whether the market is saturating for the company domestically. We estimate that despite the strong international growth potential, the U.S. still accounts for roughly 65% of Netflix’s value. Based on our analysis, we find some evidence of subscriber growth moderating and we believe that incremental customer additions will become difficult for Netflix. However, the results from the next two quarters will make the situation more clear. We believe that the stock may continue to feel the effect of subscriber miss in the coming months.

Our price estimate for Netflix stands at $300, implying a discount of about 15% to the market.

See our complete analysis for Netflix

Is Netflix’s U.S. Business Entering Maturity Phase?

Netflix added a little less than 1 million subscribers in the U.S. in Q3 2014, as opposed to its earlier expectation of 1.33 million. This was a significant miss, and resulted in about 20% drop in the stock price in the after-hours trading. One of the reasons behind the slowdown in the subscriber growth is likely to be the implementation of price increase, which likely deterred some of the new potential customers from subscribing.  There are still cheaper options available such as Xfinity Streampix and Amazon Prime. The offsetting factor of the strong reception of Orange is the New Black was not present for most of the quarter, which we believe would have resulted in lower gross additions and higher churn. Is this a one time event or does it indicate that market could become saturated in the next 2-3 years? Let’s examine Netflix’s subscriber trends through charts.

The chart above shows the comparison of Netflix’s domestic streaming subscriber additions and the company’s own guidance (mid-point) regarding the same for the last 11 quarters. It is clear that Netflix accelerated customer acquisition in 2012 and 2013 which explains the positive divergence between actual gain and guidance. However, for the last three quarters, this divergence has narrowed and became negative for Q3 2014. Clearly, Netflix’s subscriber growth is slowing down. It is not just that the company overestimated the growth potential for the third quarter. There is a clear trend since the beginning of 2014 indicating that Netflix is no longer able to produce positive surprises as far as domestic streaming business is concerned.

Here is another way to look at Netflix’s subscriber growth. The chart below shows cumulative domestic streaming subscriber base.

Looking at the chart above, we get a different story. This is a story of impressive growth as the slope of the curve is not visibly moderating yet. This indicates that the company’s domestic business may still be away from saturation. However, if the next 2-3 quarters show the continuation of what happened in Q3 2014, the shape of the above curve could change and resemble the top of the S-Curve which essentially represents the maturity phase of business life-cycle. Netflix’s business may be at a critical juncture, and may swing either way. It would be prudent to make a judgement only after looking at what happens in the next two quarters.

Risks Regarding Margins

We would like to re-iterate that cost concerns still remain valid for Netflix. Given the company’s investment in content related to its launch in additional countries in Europe, its spending on original series and its recent agreements with Internet Service Providers for interconnection fees, we believe that margin expansion may lose some steam in coming quarters. Additionally, there is going to be an increase in VAT (value-added tax) in Europe and the company expects additional international costs of roughly 5% of its revenues. It will absorb these costs and will not pass them on to its customers at this point. Thus, margin growth will be impacted.

Netflix’s total content obligations stood at a massive $7.25 billion at the end of 2013, amounting to 166% of annual revenues. This figure rose to $8.9 billion at the end of Q3 2014, notably higher than our previous expectations. By the end of 2014, Netflix’s streaming content obligation could increase to 175% of its expected 2014 revenues. That’s not something that investors will find comforting. If we consider the absolute deficit (obligations minus annual revenues), we see the figure growing from $2.89 billion at the end of 2013 to $4 billion at the end of 2014. That’s a big increase! Additionally, Netflix’s recent interconnect fee agreements with service providers raise an alarm. The company has reported notable improvement in its streaming speed and user experience after these agreements, but the speeds are still not as good as in several European countries. This suggests that domestic ISPs may charge further for speed improvement, and this could weigh on Netflix’s margins going forward.

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