Why We Revised Our Price Estimate For Netflix To $170

Netflix’s (NASDAQ:NFLX) stock has soared in the past month as the company posted better than expected growth in the international market, and witnessed over 53% growth in international streaming revenues in Q2 2017. Furthermore, the international business’ margins are improving, which should help boost the company’s overall profitability in 2017. Netflix is also witnessing growth in its average revenue per user (ARPU) for both the international and domestic streaming businesses. As a result, we have revised our price estimate for Netflix upwards to $170, which is still slightly below the current market price. Below we explain the changes that we have made to our forecast model for the company.

Despite Competition, Netflix Still Rules The Roost In The U.S.

According to Trefis estimates, the U.S. streaming subscription business accounts for around 52% of Netflix’s value. The company’s domestic subscriber base crossed the 50 million (paying subscribers) mark in Q2 and is growing at a steady pace.

Netflix faces intense – and growing – competition in the subscription video on demand (SVoD) market from companies such as Amazon (NASDAQ:AMZN) and Hulu. Furthermore, cable and content companies such as Dish Network (NASDAQ:DISH) Apple (NASDAQ:AAPL) HBO, CBS (NYSE:CBS), and Comcast (NASDAQ:CMCSA) have launched their own streaming services in recent years. Despite the competition, Netflix has been able to maintain a fairly steady growth rate due to its content library, which includes both third party and original content. Additionally, 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, as it now provides engaging and interesting content of its own. Given the secular trends within the pay-TV industry, as consumers increasingly cut the cord in favor of streaming platforms, we expect Netflix’s domestic user base to improve to over 78 million by 2024.

Furthermore, over the past few years, Netflix was able to increase the average fees paid by subscribers without any material impact on subscriber numbers. We expect that the company will be able to increase its monthly streaming subscription fees in the U.S. in the coming years, as its original content continues to grow in popularity. We now project the fee to increase to $12.50 by the end of our forecast period.

 Growth In International Subscribers To Drive Valuation

According to Trefis estimates, the International Streaming business contributes over 46% of Netflix’s valuation. We forecast that Netflix’s international subscribers will increase from around 44 million in 2016 to nearly 124 million by the end of our forecast period.

Apart from Europe and Latin America, Asia-Pacific will be a key driver of this growth. Netflix is planning to license its content in China for now, given the challenges of entering the market directly, but the company has been witnessing strong traction in India and several other Asia-Pacific markets. On the back of its local content library, we believe that the company will be able to increase its monthly streaming subscription fees in international markets in the coming years.

Steady Improvement In Margins To Boost Profitability

Netflix’s international streaming margins have improved steadily over the years, climbing from -127% in 2012 to -1% in Q2 2017. The margins have been under pressure due to unfavorable currency movements and costs related to its aggressive expansion. We believe that Netflix’s international segment could reach breakeven in 2017, and will have a positive – and steadily expanding – contribution margin in the coming years.

Another area in which Netflix has seen rapid improvement is the contribution margin for its domestic streaming segment. This margin has improved from 25% in 2013 to 38.2% in 2016. The company had earlier stated that it intends to improve its domestic streaming margin by 200 basis points per year, but now believes that the margin 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 markets. The company intends to cross the 40% threshold by 2020, and we estimate that domestic streaming margins will exceed 43.5% by the end of our forecast period.

Challenges For The Company

Focus On Content And Expansion To Escalate Costs

With so many players in the streaming space, content is likely to be the key differentiator. While Netflix initially licensed original content exclusively produced for its platform from companies such as Lionsgate and Disney, it is now developing and producing its own original content, including hits such as Stranger Things. The company has a long-term goal of ensuring that nearly 50% of the content on its platform is original. The company plans to develop 1600 hours of original content in 2017. This content has been valuable in terms of attracting subscribers, but it does require significant upfront investments. Netflix plans to fund these investments largely through debt. Debt funding would not only help the company to lower its cost of capital, but also help in ramping up the production process, particularly in international markets.

Netflix spent around $4.1 billion on content in the first half of 2017, a 40% increase from $2.96 billion in the prior year period. The company has stated that, considering the success of its original content strategy (as reflected in net additions to its subscriber base), it plans to deploy increased capital on content, particularly in owned originals. As a result, the company expects to have negative free cash flows for the foreseeable future. This will be the case in 2017, when it expects free cash flow of -$2.0 to -$2.5 billion due primarily to content expenditures.  However, once this original content has been produced, the content library can be monetized and amortized over a number of years, which should lead to an improvement in profitability over the long run. We estimate that Technology & Development Costs (As % of Revenues) will increase from 9.39% to 10.4% by the end of our forecast period. Furthermore, marketing and expansion efforts will increase General & Administrative expenses from 6.36% of revenue in 2016 to over 8.3% by 2023.

Underlying Infrastructure Can Impact Expansion

Expansion to underserved markets does present some challenges that the company did not have to deal with in developed markets such as the U.S. For one, some of these markets have relatively inconsistent internet connections and low speeds. Further, some emerging economies are “Mobile First” markets, where most video consumption happens on smartphones. High data charges on mobile phone plans can limit video consumption, and as a result these consumers prefer to download videos when a Wi-Fi connection is available and watch them later on the move. To mitigate this, Netflix launched an offline feature in late 2016 to attract mobile users. These hindrances, coupled with unfavorable secular trends such as competition from local SVoD services, can impact the growth in its international streaming subscriber base going forward.

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