Why We Are Revising Our Price Estimate For Netflix

Netflix (NASDAQ:NFLX) posted strong numbers in its quarterly earnings announcement on April 15th and the stock has jumped over 17% since then. (You can read our earnings review here.)  Subscriber growth exceeded expectations as the company added a record 4.9 million subscribers for the first three months of 2015 to take its subscriber total past 62 million globally. ^[1] User engagement is also at an all-time high and subscribers streamed 10 billion hours in Q1 2015. ^[2]

We are revising our price estimate for Netflix to $476 based on the following analysis.

See our complete analysis for Netflix

Better Than Expected Domestic Growth

Netflix added 2.3 million domestic subscribers, which soundly beat its Q1 guidance of 1.80 million. ^[2] The company’s domestic subscriber base crossed the 40 million mark and stood at 40.91 million at the end of the quarter. Netflix will face increased competition in the coming years as evidenced by the recent crowding of the online streaming market. However, we believe that the company will be able to hold its own amongst the competition. Netflix’s service functions more like a repository and 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. Consequently, we believe that Netflix’s domestic users will be just shy of 59 million by 2021.

Another area that Netflix is rapidly improving is the contribution margin for its domestic streaming segment. The contribution margin has improved from 14.3% in 2011 to around 30% in 2014. ^[1] Netflix’s domestic streaming margin stood at 31.7% for the first three months of 2015, an improvement of 370 bps over the previous quarter. ^[2] The company had previously stated that it intends to improve domestic streaming margins by 200 bps/year but now believes that it can improve even further as a larger portion of global and original content costs will now be absorbed by the company’s ever growing international territories. ^[3] The company intends to cross the 40% threshold by 2020, a target we believe to be achievable.

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 Western Europe and ANZ (Australia & New Zealand) in September 2014 and March 2015 respectively, giving it access to a combined potential subscriber base of about 74 million broadband households. ^{[4] [3]} China, Japan 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 approximately 21 million as of March 31, 2015. ^[1] We believe that Netflix can cross 60 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. ^[5] 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.

Lower Weighted Average Cost Of Capital

We have revised our discount rate (or weighted average cost of capital) downwards for valuing Netflix’s stock. This is the rate at which we discount the company’s future cash flows, and is the weighted average of its after-tax cost of debt and cost of equity. This figure is a measure of a company’s risk. Netflix justifies this revision as the stock’s beta has come down in the past year. Beta is a measure of company’s stock volatility relative to broader market. Netflix’s correlation to the broader market has improved, which means that the risk of fluctuations in its stock price has come down. The company has also been able to stabilize its business and increase its revenues without taking on substantial debt. Netflix’s total long term debt currently stands at $2.4 billion, which is significantly less than the company’s enterprise value of $33.42 billion as of April 21, 2015. ^[6] This reduces the risk in the company and warrants the revision.

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More Trefis Research

1. Netflix’s SEC Filings [↩] [↩] [↩]
2. Q1 15 Letter to shareholders, Netflix Investor Relations [↩] [↩] [↩]
3. Q1 15 Letter to shareholders, Netflix Investor Relations [↩] [↩]
4. Q3 14 Letter to shareholders, Netflix Investor Relations [↩]
5. Q4 14 Letter to shareholders, Netflix Investor Relations [↩]
6. Netflix Enterprise Value, YCHARTS [↩]