Reviewing Netflix Business In 2016

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Netflix (NASDAQ:NFLX) is facing stiff competition from local content providers such as Iflix in certain regions and global content providers like Amazon (Prime Videos) across the world.  Despite the competition, Netflix’s performance in international regions has been the primary growth driver for the company. In this note, we review the performance of Netflix’s business in domestic and international markets.

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Competition in the Streaming Industry Is Intensifying

Netflix, which started off as an online DVD rental business, had first mover’s advantage in the U.S. The company forayed into online content streaming as a logical progression arising from its DVD rental business, which was dwindling with the advent of Internet as a preferred medium of delivering content. To ensure that it continues to rule the roost in the U.S markets, Netflix has been focusing on original programming and exclusive content, which has gained popularity among its audience.

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However, Amazon launched its standalone video service in the U.S. in April this year, pricing it lower than the cost of a Netflix subscription. While Netflix was a late entrant to some of the markets outside the US, competition in these regions from local content providers is intense. For example, Sky announced a partnership with Iflix, which operates in Malaysia, Thailand and Philippines, and telecom giant Singtel, in partnership with Sony pictures and Warner Brothers, launched a video streaming service called HOOQ in 2015 in the region.

Despite this competition, Netflix’s subscriber base remains unscathed in the U.S market and is growing in international markets. The primary reason for this is the investment in original content and ability of Netflix to acquire rights to local content.  The company has an investment outlay of over $6 billion for original content development for its subscribers. Trefis believes that through the development of new content, Netflix will be able to keep competition at bay in regions where it operates.

Stable Domestic Subscriber base And Improving Profitability

Netflix’s domestic subscriber base crossed the 45 million mark this year and is still growing at a steady pace, having added 3.1 million new subscribers during the last nine months of 2016. [1] As mentioned earlier, Netflix faces intense competition in the online streaming market. Content providers such as Dish Network (NASDAQ:DISH), Sony (NYSE:SNE), Apple (NASDAQ:AAPL) HBO, CBS (NYSE:CBS), and Comcast (NASDAQ:CMCSA) have launched their own streaming service. Despite the competition, the company has been able to hold its own among the competition. With the success of Netflix’s original content, its perceived brand value has improved. 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 of its own. It is now also viewed as a complementary service rather than a competing service to various pay-TV operators. Additionally, Netflix’s service functions more like a repository and users can access, on-demand, much older content which might not be readily available on other streaming services. Consequently, its subscriber base has risen steadily by over 10.5% to 46.48 million subscribers. We believe that, as the Internet gains traction as a medium for delivering content and users continue to throng to it for on demand video, Netflix’s domestic users base will improve to over 58.8 million by 2023.

Another area that Netflix is rapidly improving is the contribution margin for its domestic streaming segment. This margin has improved from 14.3% in 2011 to 34.8% in 2015. [2] Netflix’s domestic streaming margin has continued its upward climb in the last nine months of 2016 and currently stands at 36.4% as of Q3 2016. [3] The company had earlier stated that it intends to improve domestic streaming margins by 200 bps/year but now believes that it can improve even further as a larger portion of global and original content costs will now be absorbed by the company’s ever growing international territories. The company intends to cross the 40% threshold by 2020, a target Trefis believes to be achievable.

Rapid Growth In International Subscriber Base Supplemented By Growth In Margins

The subscriber growth in Netflix’s International segment has been very robust so far, with the paid subscriber base increasing from 1.9 million customers in 2011 to over 27.43 million by the end of 2015. [2] During the last nine months, this subscriber base grew by 34.12% to 36.79 million.

Netflix has been aggressively expanding in international territories for the last two and a half years. The company has done this through the multichannel video programming distribution (MVPD) model. The company launched operations in Western Europe and ANZ (Australia & New Zealand) in September 2014 and March 2015 respectively, giving it access to a combined potential subscriber base of about 74 million broadband households. [4] [5] Netflix subsequently launched in Spain, Italy and Portugal in late 2015. In the first week of January 2016, the company expanded into 130 new countries and now has a presence in 190 countries. [6]

Additionally, Netflix has been targeting the Asia-Pacific region aggressively. South Korea, Singapore, Hong Kong, Taiwan and India were some of the other major markets that Netflix launched service in as part of the January 2016 global launch. The one notable exception is China and the company is doing all it can to enter this lucrative market. For the time being, company plans to license content to existing online service providers in China rather than operate its own service in China in the near term. It expects revenue from this licensing will be modest. We believe that Netflix will eventually enter China by collaborating with a local partner. The Asia-Pacific holds a lot of promise for Netflix as the region offers a potential target market of around 280 million households (assuming one high-speed internet connection per household). [7] We believe that Netflix will experience healthy adoption rates in the newly launched countries on the strength of its original content and its competitive pricing. As a result, we believe that Netflix can cross 80 million international subscribers by the end of our forecast period.

Netflix’s international operations are still unprofitable as the company continues to invest heavily in its expansion. Its margins have improved from -116% in 2011 to -13.7% in 2015. It further improved to -10.7% in the nine months ending September 30th 2016. [3] The company acknowledges that progress has been so strong that it now believes it can complete its global expansion phase while managing to still be profitable. This is possible as 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 positive contribution margin from 2018 onward. Trefis expects it to stabilize at around 30% by the end of our forecast period in 2023.

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Notes:
  1. Q3 16 Financial Statement, Netflix Investor Relations []
  2. Netflix’s SEC Filings [] []
  3. Q3 16 Letter to shareholders, Netflix Investor Relations [] []
  4. Q3 14 Letter to shareholders, Netflix Investor Relations []
  5. Q1 15 Letter to shareholders, Netflix Investor Relations []
  6. Netflix Is Now Available Around the World, January 6, 2016, Netflix Media Centre []
  7. List of countries by number of broadband Internet subscriptions, Wikipedia []