Netflix Q3 Preview: Aggressive International Expansion Will Continue To Boost Subscriber Growth

Netflix (NASDAQ:NFLX) will release its third quarter earnings report on October 14^th. ^[1] The company reported strong subscriber growth for the first six months of 2015. We believe that Netflix will continue to add new subscribers in the domestic market in this quarter and beyond as the streaming service will continue to hold its own amidst an increasingly competitive market. But the real star of the show will be the international subscriber growth, which will remain robust in the near future as the company expands into various new markets with the aim of having a presence in 200 countries by the end of 2016. Additionally, expansion costs will put stress on the international contribution margins in the short run, but we expect the company’s international segment to start breaking even by 2017 and start having meaningful positive contribution margin from 2018 onward.

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International Subscriber Growth Will Continue To Be Impressive

We believe that Netflix will exceed its guidance of 2.40 million subscriber additions for the quarter. ^[2] The company’s international growth has been exceptional and the subscriber base has grown by 9.4 million in the last four quarters. ^[3] Subscriber growth has been helped by the company’s aggressive expansion plan, the aim of which is to have a presence in 200 countries by the end of 2016. Netflix launched operations in six Western European countries in September 2014 and in Australia & New Zealand in March 2015, giving it access to a combined potential subscriber base of about 74 million broadband households. ^{[4] [5]} The company is also poised to launch into Spain, Italy and Portugal this month. (Related – Launching Into Spain, Italy And Portugal Makes Sense For Netflix) Additionally, Netflix has been targeting Asia in a big way and the company entered its first Asian market when it launched into Japan last month. The company recently announced that it intends to launch into South Korea, Singapore, Hong Kong and Taiwan in early 2016. ^[6] Additionally, there have been reports of the company entering India in 2016. (Related – With Eye On the Future, Netflix Could Enter India In 2016) Netflix is also very keen on accessing 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 68 million international subscribers by the end of our forecast period if it continues on its current expansion plans.

Domestic Subscriber Base Will Grow As Netflix Holds Competition At Bay

We expect Netflix to meet its guidance and add around 1.15 million new domestic subscribers to its existing subscriber base for the quarter. ^[2] The company added close to 1 million million customers in the same quarter last year. ^[3] 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 but there will be less potential for surprises on the upside. The company is set to 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, Comcast, etc., have thrown their hat into the streaming ring and will compete with Netflix in some form or the other. However, Netflix has an advantage over other streaming services 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 is also one of the cheapest online streaming alternatives available and has a tendency of being viewed as a complementary service rather than a competitor to other pay-TV and streaming alternatives. 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 Profit Margins Will Remain Negative In the Near Term

The international contribution margin improved from -34.5% in 2013 to -8.5% in 2014. ^[3] However, the contribution margin fell to -18.0% for the first half of 2015. ^[7] 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. Netflix to Announce Third-Quarter 2015 Financial Results, September 15, 2015, Netflix Investor Relations [↩]
2. Q2 15 Letter to shareholders, Netflix Investor Relations [↩] [↩]
3. Netflix’s SEC Filings [↩] [↩] [↩]
4. Q3 14 Letter to shareholders, Netflix Investor Relations [↩]
5. Q1 15 Letter to shareholders, Netflix Investor Relations [↩]
6. Netflix To Launch In South Korea, Singapore, Hong Kong And Taiwan In Early 2016, September 8, 2015, PRNewswire [↩]
7. Q1 15 Letter to shareholders, Netflix Investor Relations [↩]