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

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 by 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 the first part of this article, we explored factors which can potentially impact Netflix’s domestic operations. In this piece, we look at future developments which could disrupt the company’s international expansion plans.

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International Subscriber Growth Stalls (~10% Downside)

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. ^[1] The company provides services in around 50 countries currently and plans to reach 200 countries by the end of 2016. ^[2] China, Spain and South Korea are some other territories with fast Internet service that Netflix could venture into later. As our base case scenario, 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.

Netflix has experienced encouraging adoption rates in countries with high disposable income and fast internet connections such as the European countries and Canada. However, the company did face problems with its adoption rate in the South American countries. ^[3] Low broadband Internet penetration, low disposable income, language barriers, complications in processing internet-based payments, fewer digital devices and general skepticism about watching content on the Internet are some of the issues that the company had to face. Netflix could potentially face similar issues when it tries to expand into Asian countries which is a largely untapped market for the company. Netflix also faces competition from local streaming providers in most of the markets it enters. Such local competitors are easily recognizable, do not have a language barrier and, as a result, are looked upon more favorably by the target audience.

Netflix is hoping that the focus on original programs and movies will provide it an air of exclusivity in comparison to its rivals. However, piracy has a direct effect on the attractiveness of Netflix’s exclusive programming. Subscribers may not be interested in viewing these shows at Netflix’s paid platform when they can get the same shows for free. Piracy-tracking firm Excipio recently reported that season three of House of Cards was pirated the most in China, followed by the U.S., India, Australia, Poland, U.K., Canada, France, Greece and the Netherlands. ^[4] It is worth noting that Netflix is available in six of these countries. This shows a propensity for potential subscribers to reject Netflix’s services in favor of illegal means such as torrent downloading. Subscriber losses due to piracy could potentially gain more prominence as the company launches into countries prone to piracy, such as China, Russia, India and Australia. This coupled with earlier mentioned roadblocks such as slower internet speeds, language barriers, lower disposable income, local competition, etc., could lead to sluggishness in the growth of international subscriber base. In such a scenario, Netflix’s international subscriber base might not grow beyond 40 million in the next six to seven years. Consequently, the price estimate for the company would then come down to $339, implying a downside of approximately 10% to our current estimate of $376.

International Content Costs Increase At A Faster Clip (~15% 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. ^[2] 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. This is especially true for the international segment which has not been profitable on a contribution basis until now. We currently 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 cross the 30% mark by the end of our forecast period.

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 international streaming contribution margin would not be able to cross 20% by the end of our forecast period. This could lead to a potential downside of around 15% to our price estimate.

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1. Netflix’s SEC Filings [↩] [↩] [↩]
2. Q4 14 Letter to shareholders, Netflix Investor Relations [↩] [↩]
3. Netflix faces problems in Latin America, May 16, 2012. Los Angeles Times [↩]
4. ‘House of Cards’ Season 3 Pirated, With China Top Country for Downloaders, March 1, 2015, Variety [↩]