Netflix Earnings Preview: Strong Growth Expected

Netflix (NASDAQ:NFLX) will release its third quarter earnings on Oct 21. While the net domestic streaming subscriber additions are likely to jump compared to Q2 2013 due to seasonality, the mid point of the guidance range suggests that there may not be meaningful growth in the metric compared to the second quarter of 2012. That said, Netflix’s continued investment in content and its user interface will allow it to sustain growth in the both domestic as well as international markets in the near term. As customers increasingly become aware of the company’s original content, there will be some additional benefit from positive word-of-mouth marketing. The flip side is that Netflix will continue facing declines in its DVD subscriber base.

While we believe that the company will continue to benefit from the growing demand for streaming, a possible slowdown in the U.S. and mounting content obligations can be a cause of concern. Our price estimate for Netflix stands at $163, implying a discount of about 50% to the market price.

See our complete analysis for Netflix

Continued Content Investment & Service Improvements Will Support U.S. Subscriber Growth

Netflix has been making concerted efforts to differentiate its streaming content. This has been one of its biggest growth drivers in recent quarters and there is no reason why Q3 will be any different. The company has acknowledged that the launch of original series such as Arrested Development and House of Cards led to a jump in subscriber additions during the first half of the year. Netflix is effectively marketing these exclusive shows to maintain its growth momentum, and furthered its content advantage during the third quarter by sealing a multi-year deal with The Weinstein Company. Starting 2016, Netflix will have the rights to show the movies produced by The Weinstein Company during the pay-TV window. ^[1] Last year, the company signed a similar deal with Disney (NYSE:DIS) to gain exclusive access to some of its content 2015 onwards (see What Are The Implications Of Netflix’s Deal With Disney?). Clearly, Netflix is investing substantially for its long-term growth which is a good sign for its shareholders. During the first half of 2013, it struck content deals with Turner Broadcasting, Warner Brothers Television Group, DreamWorks Animation and Hasbro Studios, Disney and DreamWorks Animation.

Netflix also enhanced its user interface by introducing the ‘profile’ feature during the third quarter. This functionality allows members of a household to create separate profiles on the same Netflix account to get more personalized experience. There is a lot of value in these subtle improvements and this is another area where the company has an edge over its competitors.

Continued Uptake In International Markets & Netherlands Launch

We expect Netflix to deliver strong results on the international front and add close to 1 million subscribers. Last quarter’s net subscriber additions were relatively close 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 September 2013, the company launched its service in Netherlands which will have a minor impact on its third quarter results. Netflix’s ambitions are being 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.

Risk: Possible Slowdown In The U.S. & Rising Content Costs

The 2nd quarter saw a steep sequential decline in net U.S. streaming subscriber additions due to seasonality. The company expected the figure to decline compared to Q2 2012 as well, but the launch of Arrested Development towards the end of May temporarily fueled gross subscriber additions. ^[2] In the third quarter, Netflix expects to gain roughly 1.09 million net domestic streaming  subscribers (mid-point of guidance) which is slightly lower than the figure for Q3 2012. These facts suggest that Netflix has gotten big enough in the U.S. and might start to witness some slowdown in its growth. This is a cause of concern as the U.S. streaming business constitutes roughly 60% of the company’s value according to our estimates. It is the profitability of this business that has armed Netflix with enough capital to invest in international expansion without raising much debt. This risk may be negated if the company can successfully partner with U.S. pay-TV operators, similar to what it recently did in Europe.

Additionally, Netflix’s streaming content obligations have grown in the last few quarters. The figure stood at $4.97 billion in Q3 2012 and increased to $6.37 billion by Q2 2013. ^[3] The jump in the second quarter was significant and the growing competition can be a cause of concern. Amazon (NASDAQ:AMZN) and Hulu are making significant content investments which can make it very expensive for Netflix to acquire new programming. Amazon is spending $1 billion in licensing content and Hulu has received $750 million from its parent companies to improve its streaming content library. The influx of all this cash could push the prices up.

Understand How a Company’s Products Impact its Stock Price at Trefis

1. Netflix and The Weinstein Company Announce Multi-Year Premium Pay TV Window Agreement in the United States, Netflix Press Release, Aug 20 2013 [↩]
2. Netflix’s Q2 2013 Earnings Transcript [↩]
3. Netflix’s SEC Filings [↩]