Why We Are Revising Our Price Estimate For Netflix

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Netflix (NASDAQ:NFLX) posted strong numbers in its quarterly earnings announcement on January 20th and the stock has jumped over 25% since then. Subscriber growth was back on track as the company added 4.3 million subscribers for the last three months of 2014 to take its subscriber total past 57 million globally. The company has overcome the disappointing third quarter results and its international operations continue to strengthen. We are revising our price estimate for Netflix to $376 based on the following analysis.

See our complete analysis for Netflix

Higher Growth In Average Revenue Per Subscriber And Margins In The U.S.

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Netflix had earlier cited in their Q3 letter to shareholders that the recent price hike might have been a factor in the disappointing domestic subscriber growth for that quarter. The company has performed additional research since then and has mentioned in the Q4 letter to shareholders that the price rise did not materially impact the subscriber numbers. It has found that the strongest growth in its subscriber base has been in the lower income areas of the US, which would not be the case if there was material price sensitivity. [1] Additionally, it implemented a similar price increase in Mexico during the fourth quarter and saw no detectable change in subscriber growth. Netflix had also implemented a price increase in 2011 which was largely accepted after the initial resistance. This leads us to believe that Netflix has the capacity to implement a price increase every two to three years without suffering materially on the subscriber front.

Another factor that gives Netflix the flexibility to raise prices more consistently is the fact that the average fee paid by a Netflix subscriber is around $7.90 which is significantly less than the average fee that customers pay for their Pay-TV connections. The average Pay-TV fees depend on the type of content provider and the type of plan selected but are generally upwards of $60.00 per month. Netflix also shielded their long term users from the recent price increase for two years. These customers will start paying the increased fee for 2016 which also help in boosting the average revenue figure. We expect that the average revenue per customer will climb up to around $9.70 in the next six to seven years.

Another area that Netflix is rapidly improving is the contribution margin for its US streaming segment. The contribution margin has improved from 14.3% in 2011 to around 30% in 2014 and the company expects that it can further improve margins to around 40% by 2020. We believe that the increase in the average fees paid by subscribers due to the reasons mentioned above will go a long way in reaching the 40% target in the future.

International Expansion Will Start Paying Off

Netflix’s international operations are still unprofitable as the company continues to invest heavily in its expansion. Going forward, Netflix’s international expansion could have a significant impact on both its subscriber additions as well as contribution margins. The company launched operations in France, Germany, Austria, Switzerland, Belgium and Luxembourg in September 2014, which gives it access to a potential market of about 66 million broadband households. [2] It also officially announced that it plans to launch in Australia and New Zealand in March 2015. China, Japan, Spain and South Korea are some other territories with fast Internet service that Netflix could venture into later. The subscriber growth in the International segment has been very robust so far, with the subscriber base increasing from 1.9 million customers in 2011 to 18.3 million by the end of 2014. We believe that  Netflix can cross 50 million international subscribers by the end of our forecast period if it continues on its current expansion plans.

The markets that Netflix launched into prior to 2014 (Canada, Latin America, the UK, Ireland, the Nordic countries and the Netherlands) became profitable on a contribution basis in Q3 2014 and continue to grow. [1] The company acknowledges that progress has been so strong that it now believes it can complete its global expansion over the next two years while managing to still be profitable. This is possible as Netflix will start experiencing operational efficiencies as it grows operations in the target countries. The marketing expenses will also come down as a percent of sales once the company establishes itself in these countries. We believe that Netflix’s international segment will start to break even by 2017 and will start having positive contribution margin from 2018 onward. It will then stabilize at current domestic levels by the end of our forecast period.

Focus On Original Content Will Continue To Help Netflix

Netflix’s original content has improved viewers’ perception of the overall brand. The company’s original programming has garnered critical acclaim by scoring multiple Emmy, Golden Globe and Academy Award nominations and several wins in the last two years. Shows such as House of Cards and Orange Is The New Black have generated unprecedented success. The company plans to build on this success by growing the percentage of its content spending dedicated to original content in the coming years. The company will launch 320 hours of original content in 2015, triple the amount of original programming Netflix released in 2014. Included in the shows to be broadcast are Marvel shows Daredevil and AKA Jessica Jones, brand new seasons of the hit originals House of Cards and Orange is the New Black, as well as an original Adam Sandler comedy. Adding to this list are the second season of the $90 million dollar Marco Polo, the sci-fi series Sense8 created and directed by the Wachowskis, Tina Fey’s Unbreakable Kimmy Schmidt and a sequel to Crouching Tiger Hidden Dragon. These series will be part of a roster of 30+ upcoming original series that Netflix plans to broadcast by the end of 2016. The focus on original programs and movies gives Netflix an air of exclusivity in comparison to its rivals. The company is no longer considered just an aggregator of popular content from other networks and has come of age as a provider of engaging and interesting content on its own.

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Notes:
  1. Q4 14 Letter to shareholders, Netflix Investor Relations [] []
  2. Q3 14 Letter to shareholders, Netflix Investor Relations []