Netflix Earnings Preview: Content Investments To Drive Growth

Netflix (NASDAQ:NFLX) will release its Q2 2013 earnings on July 22. While the net subscriber additions will come down compared to Q1 due to seasonality, we expect them to be closer to the higher end of the guidance keeping in mind the company’s last quarter’s results and its investment in streaming content. We expect good seasonally adjusted growth for the company’s U.S. streaming service, and its international business will benefit from continued uptake in Europe, Canada and Latin America. The flip side is that Netflix will continue to face declines in its DVD subscriber base. Let’s take a closer look at what to expect from the upcoming earnings.

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Arrested Development & Other Original Content Will Support U.S. Subscriber Growth

Netflix stated that its content advantage was the biggest driver of its U.S. streaming subscriber growth in the first quarter of 2013. While the net subscriber additions will come down in Q2 as compared to Q1 due to seasonality, the launch of original series Arrested Development towards the end of May will lend some support. The company has been adding original and exclusive programming to its streaming library, which seems to be paying off. TV series such as House of Cards, Lilyhammer and Arrested Development are drawing lot of audience and attracting customers to sign up. In fact, Netflix has effectively marketed these exclusive shows to maintain its subscriber momentum.

The company is also benefiting from the proliferation of smartphones, tablets and other connected devices as well as general consumer shift to the Internet. Its streaming service constitutes almost 30% of peak Internet traffic in the U.S. Although the competition is increasing, the company has the first mover advantage since it pioneered the subscription streaming service. Besides some of the exclusive shows that we mentioned before, Netflix also signed a deal with Disney (NYSE:DIS) last year, to gain exclusive access to some of its content, once the contract between Starz and Disney expires in 2015 (see What Are The Implications Of Netflix’s Deal With Disney?). During the first quarter of 2013, the company struck content deals with Turner Broadcasting, Warner Brothers Television Group, DreamWorks Animation and Hasbro Studios. In the second quarter, it signed another content deal with Disney for some of the popular shows available on Disney Junior and Disney XD. In addition to this, it also announced a multi-year deal with DreamWorks Animation, which will give it distribution rights to DreamWorks’ original TV series. This is the largest original content deal in Netflix’s history and showcases the importance of kids-focused programming and the company’s continued commitment in bringing in original content to its subscribers.

Netflix will continue to benefit from the growing demand for streaming, which is evident from the fact that almost all pay-TV companies are making efforts to complement their traditional pay-TV packages with streaming. For instance, Comcast has started its streaming service Xfinity Streampix, which is available to its subscribers for an additional charge of $4.99 per month. Time Warner Cable is offering a live TV streaming app and Dish Network (NASDAQ:DISH) acquired Blockbuster to enter the streaming arena. Amazon (NASDAQ:AMZN) and Verizon (NYSE:VZ) (in partnership with Redbox) are also offering their streaming services for low prices.

International Business Will Benefit From Continued Uptake

We expect Netflix to deliver strong results on the international front and add more than half a million subscribers. Last quarter’s net subscriber additions were closer to the high end of its guidance. This suggests that the business is doing better than expected and this could reduce losses going forward. Currently, Netflix is present in Europe, Latin America and Canada. In Europe, it plans to expand to Netherlands in late 2013. Netflix’s ambitions are fueled by its rejuvenated growth in the U.S., that allows it to generate enough cash to invest in international expansion.

With Canada and Europe being developed markets, Netflix is positioned well to capture market share in these regions. The broadband penetration is high and average broadband speeds are good enough to foster growth in streaming services. Overall, we believe that Netflix can target a total of 38 million households in its current markets in Europe, and can gain more than 12 million subscribers over the long term, if it can emulate its success in the U.S. in these markets and can achieve a penetration close to 30% of households.

In addition to this, Latin America presents good potential despite a slow start. The growing middle class, an expected improvement in payment systems and the lack of pay-TV penetration can help Netflix. We believe that if the company can achieve a penetration of even 5% in Latin American households over the next six to seven years, it can gain close to 7-8 million subscribers in this region alone.

High Margin DVD Rental Business Will Continue To Decline

The first quarter of 2013 saw net DVD subscriber loss of about 240,000. We expect these declines to persist as Netflix continues to improve its streaming content. However, the DVD rental business is still a high margin one for the company. Although it expects to maintain these margins in 2013, the decline is inevitable as the subscriber base shrinks.

The primary costs governing these margins include revenue sharing and content acquisition costs, postage costs and DVD shipment center costs. While revenue sharing costs and postage costs are variable, other costs have large fixed components. With a smaller number of DVDs to handle, the company may lose out on the advantage of economies of scale and its distribution centers may not run as efficiently as they used to. In addition to this, the company may not get favorable pricing from studios due to a shrinking base and less negotiating power. The fixed costs of content acquisition will be spread out over a smaller revenue base, implying that Netflix will lose operating leverage. Moreover, rising postage costs will also put some pressure on its margins.

Our price estimate for Netflix stands at $156, implying a discount of more than 40% to the market.

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