Netflix (NASDAQ:NFLX) is enjoying rapid expansion riding on the popularity of DVD-by-mail and online streaming. In March, we wrote Are Netflix’s International Ambitions Justified & Achievable? where we looked at whether market saturation was a significant risk for Netflix and if international expansion could help provide an additional source of subscriber growth. Netflix has signaled that it plans to expand abroad, and we believe that the UK could be high on the list of new markets in addition to Latin America.
We recently upgraded our price estimate to $153 as a result of continued subscriber growth momentum reported in Q1 2011; however, our estimate still stands around 30% below the market price. Netflix competes with Apple’s (NASDAQ:AAPL) iTunes and Hulu as well as video on demand (VoD) services from pay-TV providers like Comcast (NASDAQ:CMCSA), Time Warner Cable (NYSE:TWC) and others.
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We highlighted in past notes some of the challenges for Netflix in international markets and how international expansion may not fuel the kind of subscriber growth needed to justify the current market valuation. Netflix had originally planned to expand into Canada and the UK several years ago, but ended up shelving those plans in 2004 as competition for the US market intensified. 
Since then, Netflix has established a dominant position in the US rental market and launched its streaming service in Canada. We believe that the UK is high on the list of new geographies that Netflix will pursue next as part of its international strategy, which we discuss below.
UK Movie Rental Market at a Glance
According to one in depth report, the UK was the third-largest filmed entertainment market in the world in 2008 with the US commanding a mammoth 42% share and Japan coming in second.  Online rental has been a hit in the UK and the firm estimates that in 2007, online rentals formed about 30% of the UK film rental market.  Additionally the most famous genre in the UK is comedy which accounted for about 24% of total rentals in 2008.  This was closely matched by drama as well as action titles.
Although the figures are somewhat outdated, they do provide a guidepost of sorts on how the UK stacks up in terms of movie rentals.
The UK Market: California and Texas Combined
When Netflix launched in Canada, we had compared the Canadian market to California in terms of population and households. In comparison, the UK market is equivalent to the two most populous US states, California and Texas, combined. The following tables show population, household and internet subscription data for the UK.  
According to these tables, the total number of households in the UK stands at little over 26 million, which is less than 23% of the households in the US. While internet households are around 19.2 million, not all of them are broadband. Thus we are left with about 18.7 million broadband households that can potentially subscribe to a service like that offered by Netflix.
UK Broadband Bottleneck?
However, not all of the UK’s internet households have connections that could support streaming uninterrupted. As evident from the table above, the number of households with broadband speed of more than 2 Mbps stands at an estimated 13 million.
So why 2 Mbps? Many of the high quality videos from Netflix are encoded at a bit rate of more than 2 Mbps and will require high speeds for uninterrupted streaming. While Netflix can support slower speeds, the quality is lower and not as appealing to users.  Moreover, due to a shift towards HD videos, higher broadband speeds will become increasingly necessary.
GigaOM states in one of its posts that UK is still lagging when it comes to broadband.  The UK government’s target to make 2 Mbps connections available to everyone seems to have been pushed from 2012 to 2015 due to lack of funds. According to a study from Saïd Business School of Oxford University released in October, the UK ranked 17th in broadband leadership.  In comparison, the same study ranked the US and Canada both as 15th while countries such as South Korea and Japan were near the top of the list.
UK Film Rental Competition
The competition already exists and Netflix does not have a totally untapped market in which to expand. The table below shows some of these competitors and their businesses models. 
While it seems Netflix has certain advantages in terms of the price and content over LoveFilm, low-cost streaming access appeals to consumers over on-demand giants like BskyB, there are a few concerns.
Amazon (NASDAQ:AMZN) has already acquired remaining equity stake in LoveFilm.  This can give Amazon a better access to UK film rental market and with Amazon’s backing, LoveFilm could pose stiff competition to Netflix if the company enters European markets. Amazon has grown quickly in e-commerce and certainly has the capacity to pump more cash to enrich LoveFilm’s content. Additionally, Blockbuster can do better in the UK by taking heed of what happened to it in the US. See our previously published article Blockbuster Bankruptcy: Good or Bad for Netflix? on how Blockbuster can emerge stronger even in the US.
Physical DVDs Still in Demand
One of the backers of LoveFilm stressed the importance of a hybrid streaming and DVD rental model in the UK. Citing the troubles faced by a UK video-on-demand service called Home Choice, he indicated that the rapid transfer to a purely digital approach will not work in the UK in the short-term. Netflix has succeeded to date in the US with a hybrid model and the absence of this model internationally may slow the adoption of Netflix abroad.
Overall, the UK might be one of the more promising markets to expand to internationally, but Netflix’s subscriber gain potential here could be quite limited. You can modify our forecast for Netflix subscribers below to see what the potential upside for our Netflix estimate might be if the company were to realize significant subscriber adoption in the UK.Notes:
- Netflix, Blockbuster in all-out DVD rental price war, USA Today online, Oct 14, 2004 [↩]
- Movie Rental Industry Drives Home Entertainment Market, marketresearch.com, Dec 1 2009 [↩] [↩] [↩]
- The data for population, households, internet households, % of broadband subscribers with >2mbps connection are taken from http://www.statistics.gov.uk [↩]
- The data for broadband households is taken from “When it Comes to Broadband, UK Still A Laggard, GigaOM article dated 16 July 2010“. Additionally the data for TV households is taken from “http://www.barb.co.uk/about/tvMeasurement“ [↩]
- Encoding for streaming, blog.netflix.com, Nov 6 2008 [↩]
- When it Comes to Broadband, UK Still A Laggard, GigaOM, July 16 2010 [↩]
- Third annual broadband study shows global broadband quality improves by 24% in one year [↩]
- The data for competitors has been primarily taken from the article “Movie streaming, mad.co.uk, 19th Aug 2010“, Additionally Blockbuster data is from “Blockbuster files for bankruptcy in US, bbc.co.uk, 23 Sept 2010“ [↩]
- Amazon acquires LoveFilm, the Netflix of Europer, TechCrunch, Jan 20 2011 [↩]