Is Netflix’s Business Sustainable At Its Current Prices?

Netflix (NASDAQ:NFLX) had faced a strong backlash from its subscribers in 2011 when it suddenly raised its prices. Subsequently, it focused on improving its service and streaming content in order to regain customer confidence. This worked well as evident from the subscriber gains in the last few quarters. However, this subscriber growth has come at a great expense. In 2012, Netflix’s content spending as a percentage of revenues doubled primarily due to significant investments in its international business.

This begs the question – can Netflix sustain its growth without raising prices?

If we look at how the company’s costs are trending, we don’t see a pretty picture. Content expenses have ballooned leading to a sharp decline in EBITDA (earnings before interest, taxes, depreciation and amortization) margins. Content obligations, which earlier seemed to be stabilizing, jumped again in the second quarter of 2013. Content costs are going to rise in the future as competitors bid up the prices. There is a good chance that Netflix will resist increasing prices as it tries to stabilize its international business. However, from a long term perspective, we believe the company may need to resort to higher pricing as the proportion of expensive original content increases. A lot depends on how its international operations fare over the next year or two.

Let’s take a brief look at Netflix’s increasing costs which point towards the necessity of a price rise at some point.

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Content Cost Trends Don’t Look Too Encouraging

Netflix’s content costs have risen substantially over the last few years due to its efforts to expand its streaming library both in the U.S. and international markets. Back in 2011, Starz was demanding as much as a ten-fold increase in payments for the renewal of its content contract with Netflix. This would have amounted to an annual payment of around $300 million compared to its original deal of close to $30 million. This is a classic example demonstrating how streaming content costs have skyrocketed in recent years as competitors are bidding up the prices and media companies are realizing the value of their content.

Netflix hasn’t shied away from spending to keep its subscribers hooked. The company stated that its content advantage was the biggest driver of its U.S. streaming subscriber growth in the first quarter of 2013. Netflix has been adding some 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 audience and attracting customers to sign up. In fact, Netflix has effectively marketed these exclusive shows to maintain its subscriber momentum. It is estimated that Netflix is paying somewhere around $4 million per original episode.

The company has ordered the second season of all its first season projects, which reflects the popularity of its original series among its customers. The quality of the programming is good given that Netflix’s original series were nominated for 14 Emmy awards, with most of those nominations coming from House of Cards. Next year, the company plans to premiere the second season of House of Cards, Hemlock Grove, and Orange is the New Black, and debut Sense 8 and several kids-focused original programs.

These content deals do not come cheap, which is evident from the significant jump in Netflix’s streaming content costs, overall content costs and streaming obligations over the last two years. The trend has continued in the first half of 2013 as well.

Overall Margins Have Declined

Even though Netflix gained some operating leverage and reduced its general and administrative expenses as a percentage of revenues, its research and development costs have increased. EBITDA margins declined slightly in 2011 followed by a sharp fall in 2012 as the company made significant content investments to expand internationally. The table below shows how Netflix’s EBITDA margins have trended in recent years and demonstrates that the business is at a critical stage. This figure is adjusted to exclude stock-based compensation.

Our price estimate for Netflix stands at $171, implying a discount of about 35% to the market. The price estimate is based on our expectation that the company’s EBITDA margin will improve slightly in 2013, and continue to grow thereafter to 18% by the end of our forecast period. Therefore, we believe that the market is being over optimistic about Netflix’s stock when clearly there exists a significant risk. It may be hard for the company to improve its margins significantly without raising its prices at some point.

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