Factors That Can Lead To A Significant Change In Netflix’s Valuation (Part I)

Conventional pay-TV industry is reaching saturation at a rapid pace and consumers are increasingly shifting to alternative platforms such as online streaming services in order to consume content. Streaming giant Netflix (NASDAQ:NFLX) has been one of the biggest beneficiaries of this changing trend and its global subscriber base has increased from 23.5 million in 2011 to 57.4 million at the end of 2014. ^[1] The company has also managed to grow its average revenue per customer during this period. Additionally, the success of Netflix’s original content has improved viewers’ perception of the overall brand. 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.

As our base case scenario, we believe that the company will continue to expand its operations in the coming years and its global subscriber base and average revenue per customer will continue to grow. Our price estimate for Netflix stands at $376, implying a discount of about 14% to the market. However, there are certain triggers and plausible developments that can move the stock significantly in the next couple of years. In Part-I of the article, we take a look at how future developments can potentially impact Netflix’s domestic operations. In Part-II, we will be focusing on factors which might disrupt Netflix’s international expansion plans.

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Domestic Subscription Fees Grows At A Faster Rate (~10% Upside)

At a base package of less than $10 per month, Netflix’s subscription fee is considerably cheaper than an average pay-TV plan, which is generally in excess of $60 per month. As a result, Netflix has enjoyed some pricing power and was able to raise its subscription fee in 2011 ^[2] and in 2014 ^[3]. Unfortunately, the recent crowding of the online streaming market reduces Netflix’s pricing power. Content providers such as Dish Network, Sony, Apple, HBO, CBS, etc., have all announced the launch of their own streaming service within the last year or so. These services will be priced somewhere in between the subscription fees charged by traditional pay-TV providers and Netflix. These services will have an advantage over Netflix as they will broadcast live content whereas the same content will be made available on Netflix after it is syndicated. Keeping all this in mind, we have taken a conservative growth estimate for the average revenue per domestic subscriber in our base scenario. Accordingly, we estimate that the figure will grow from a current value of $7.88 to $9.70 by the end of our forecast period.

However, Netflix has an advantage of its own as it functions more like a repository and users can access much older content which might not be readily available on other streaming services. Additionally, Netflix has a tendency of being viewed as a complementary service rather than a competing service to various pay-TV operators. The end users could potentially form the same opinion of the company when it is compared to other streaming services in the future. Netflix hopes to increase its attractiveness further on the basis of its original content. The company plans to build on the success of its original shows, such as House of Cards and Orange Is The New Black, by growing the percentage of its spending dedicated to original content in the coming years. In an optimistic scenario, the exclusivity of its future original content, along with its repository and complementary services, could keep the competition at bay and help in increasing the company’s average revenue per domestic subscriber at a faster rate to $11.00 by 2021. Consequently, the price estimate for the company would then climb to $413, implying a premium of approximately 10% to our current estimate of $376.

Domestic Content Costs Could Rise At A Faster Clip (~10% Downside)

Content costs have been rising steadily for Netflix. The company’s streaming content obligations increased from around $7.3 billion in 2013 to approximately $9.5 billion by the end of 2014, a jump of around $2.2 billion. ^[1] The company has no plans to slow down in the near future and will launch 320 hours of original content in 2015, triple the amount of original programming Netflix released in 2014. ^[4] Content expenses, which include the amortization of the streaming content library and other expenses associated with the licensing and acquisition of streaming content, are the largest cost component for Netflix’s cost of revenue and account for over 75% and 87% of the total domestic and international expenses respectively. The effect of increasing content costs can be felt in the contribution margins of both the domestic and international streaming segments. We currently believe that the rise in content costs will not exceed the growth in revenues, keeping the margins in check. Consequently, the domestic streaming contribution margin will improve to over 40% in the next six to seven years.

However, the recent crowding of the online streaming market could induce Netflix into spending more on content in order to keep the competition at bay. Additionally, there is no guarantee that the content Netflix buys will be successful. If some of its shows fail, the company will have to pump in more money in order to secure content which will attract consumers. A potential rapid increase in content costs will erode margins and, in this scenario, the domestic streaming contribution margin would not be able to cross 35% by the end of our forecast period. This produces a potential downside of around 10% to our price estimate.

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1. Netflix’s SEC Filings [↩] [↩]
2. Netflix Introduces New Plans and Announces Price Changes, July 12, 2011, Netflix US & Canada Blog [↩]
3. Netflix Hikes U.S. Streaming Plan by $1 per Month for New Members, May 9, 2014, Variety [↩]
4. Q4 14 Letter to shareholders, Netflix Investor Relations [↩]