Netflix Earnings Preview: Subscriber Growth Accompanied By Pressure On International Margins

Netflix (NASDAQ:NFLX) will release its Q1 2015 earnings on April 15^th. The company reported strong subscriber numbers in the last quarter after an unexpected miss in Q3 2014. For the current quarter, we expect that the overall customer base will continue to grow.  However,  the rate of growth of  domestic subscribers is likely to come down compared to the same period last year, as the market is slowly approaching the point of saturation. Additionally, continued expansion will put stress on international contribution margins.

Our price estimate for Netflix shares stands at $376, implying a discount of about 17% to the market.

See our complete analysis for Netflix

Expect Solid But Unspectacular Domestic Subscriber Growth

We expect Netflix to report the addition of  1.80 million new domestic subscribers to its existing subscriber base for the quarter, as guided. ^[1] The company marginally exceeded its expectations in the last quarter, adding 1.90 million subscribers domestically, as opposed to its guidance of 1.85 million. ^[2] We believe that Netflix’s US business could be entering its maturity phase and that the subscriber growth will be solid for the next couple of years but there will be less potential for surprises on the upside. The company will also face increased competition in the coming years as evidenced by the recent crowding of the online streaming market. 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. The newly launched services will have an advantage over Netflix, because they will broadcast live content.  In contrast, the same content will be made available on Netflix after it is syndicated.

However, Netflix has an advantage of its own as it functions more like a repository or archive.  Users can access much older content which might not be readily available on other streaming services. Netflix also tends to be 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. 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.

International Subscribers Will Continue To Grow Rapidly

We believe that Netflix will meet its guidance of 2.25 million international subscriber additions for the quarter. ^[1] The company registered a stellar performance in the international segment last quarter as the subscriber base grew by a record 2.43 million customers. Subscriber growth was helped by the company’s launch in France, Germany, Austria, Switzerland, Belgium and Luxembourg in September 2014. ^[1] This launch adds about 66 million broadband households to Netflix’s addressable market and will continue to benefit the company in the years to come. ^[3] Netflix also launched its services in Australia and New Zealand in March 2015 and plans to enter Spain later in the year. China, Japan and South Korea are some other countries 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 at the end of 2014. ^[2] We believe that Netflix can cross 50 million international subscribers by the end of our forecast period if it continues its current expansion plans.

International Profitability Will Suffer In The Short Term

The international contribution margin improved from -34.5% in 2013 to -8.5% in 2014. ^[2] However, we expect this number to drop in the near term as the expansion into new countries will put severe stress on margins. This is primarily due to the lack of operating leverage that Netflix will face in these new markets, since the subscriber count will be low in the initial period and many new subscribers will be in the trial phase. Large marketing expense in the countries where the service has been recently launched is unavoidable. All these factors will contribute to a period where the top-line growth will not generate profitability for the international segment of the company.

However, 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.

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1. Q4 14 Letter to shareholders, Netflix Investor Relations [↩] [↩] [↩]
2. Netflix’s SEC Filings [↩] [↩] [↩]
3. Q3 14 Letter to shareholders, Netflix Investor Relations [↩]