Netflix Q2 Earnings Preview: Subscriber Base Will Grow But International Margins Will Remain Negative

Netflix (NASDAQ:NFLX) will release its Q2 2015 earnings on July 15^th. The company reported strong subscriber numbers in the last two quarters 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 in domestic subscribers is likely to come down compared to the same period last year as the U.S. market slowly moves towards the point of saturation. On the other hand, International subscriber growth will remain robust in the near future as the company expands into various new territories with the aim of having a presence in 200 countries by the end of 2016. Additionally, expansion costs will put stress on international contribution margins in the short run, but we expect the company’s international segment to start breaking even by 2017.

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Domestic Subscriber Base Will Continue To Grow Amidst Increasing Competition

We expect Netflix to meet its guidance and add around 0.60 million new domestic subscribers to its existing subscriber base for the quarter. ^[1] The company added 0.57 million customers in the same quarter last year. ^[2] We believe that Netflix’s U.S. business could be entering its maturity phase and that the subscriber growth will be solid for the next couple of years.  However, 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., are some of the new players who have either launched their own streaming service or are planning to launch soon. These services are priced somewhere in between the subscription fees charged by traditional pay-TV providers and Netflix. The newly launched services have an advantage over Netflix as they broadcast live content whereas the same content is only made available on Netflix after it is syndicated.

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. Netflix also 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. 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 Subscriber Growth Will Be Robust

We believe that Netflix will exceed its guidance of 1.90 million 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 2.6 million customers. Subscriber growth was helped by the company’s launch in six European countries in September 2014, which gave it access to a potential market of about 66 million broadband households. ^[3] Netflix also launched its services in Australia and New Zealand in March 2015 and met with a positive initial response. The company is also poised to launch into Japan, Spain, Italy and Portugal later this fall. (Related – A Closer Look At Netflix’s Foray Into Japan) There have also been reports of Netflix entering India in 2016. (Related – With Eye On the Future, Netflix Could Enter India In 2016) China, Japan and South Korea are some other territories with fast Internet service that Netflix could venture into later. The company is very keen on entering the Chinese market and is exploring potential routes for entry. (Related – China Makes Sense For Netflix, But It Won’t Be Easy) 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 almost 21 million as of March 31, 2015. We believe that Netflix can cross 61 million international subscribers by the end of our forecast period if it continues on its current expansion plans.

International Profit Margins Will Remain Negative In the Short Term

The international contribution margin improved from -34.5% in 2013 to -8.5% in 2014. ^[2] However, the contribution margin fell to -15.6% during the first three months of 2015. ^[1] We expect this number to continue 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 expenditure in the countries where the service has been recently launched is also 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 meaningful 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. Q1 15 Letter to shareholders, Netflix Investor Relations [↩] [↩] [↩]
2. Netflix’s SEC Filings [↩] [↩]
3. Q3 14 Letter to shareholders, Netflix Investor Relations [↩]