Netflix (NFLX) has had a rough start to 2014, as the stock has fallen 9.4% since the start of the year, far outpacing the NASDAQ. However, the company continues to show it's a force in home entertainment, and the company continues to roll out internationally, shares could have almost 60% upside to them.
Pacific Crest Securities analyst Evan Wilson, who has a $500 price target on shares, believes that Netflix's international expansion will start to "accelerate meaningfully" over the next 18 months, and could blow away subscriber and revenue estimates through 2016.
During the fourth quarter, Netflix added 1.74 million subscribers internationally, giving the Los Gatos, Calif.-based company 10.93 million users. Netflix said it expects to add 1.6 million international users in the first quarter, as the opportunities ahead of the company continue to remain large. "Our success this year in international net additions and shrinking contribution losses confirms our belief that there is a big international opportunity for Netflix," CEO Reed Hastings said in the letter to shareholders.
Wilson notes that international margins look as if they're doing better than in the U.S., "which suggests international profitability could match or exceed U.S. profitability over time." Incremental contribution margins for Netflix's international business has averaged 55% over the past two years, Wilson noted. Overall streaming margins hit 23% in the fourth quarter.
Netflix said it expects to reach 30% contribution margin in 2015, but Hastings said once that level is hit, it'll be harder to keep growing at 400 basis points per year.
As Netflix continues to gain scale (it now has 33.4 million streaming subscribers in the U.S., with 31.7 million paying), the company could raise prices, given the value customers are getting. "We estimate the average U.S. Netflix subscriber is paying $0.16 per hour viewed, versus approximately $0.50 for the average pay TV subscriber, which suggests significant latent pricing power," Wilson wrote in the note. The analyst said that even a $1 increase to Netflix's average revenue per user (ARPU) would boost his 2016 operating income estimate by 84% to $1.61 billion.
Given how strong Netflix is with U.S. consumers and the value it provides, Wilson estimates there's the potential for Netflix to raise prices significantly over the next few years, bringing it into parity with how much traditional pay TV costs. Wilson notes if Netflix came into parity with pay TV, Netflix would cost $25 a month, way more than the usual $8 a month subscription most people have.
Not only could Netflix raise prices, given the company's advantages in over-the-top (OTT) streaming services, Netflix could also move into ad-supported video, Wilson notes, "and add a meaningful profit opportunity that is not captured in current models."
Price Waterhouse Coopers estimates the global ad market for television is over $160 billion, and right now, Netflix captures none of that. Though Netflix does not currently have an ad-supported model, Wilson believes there are major benefits to having one, outside of additional revenue. "Just as importantly, we believe expanding into the ad-supported business would provide additional data that would likely help Netflix optimize its mix of content purchasing and monetization in both its subscription and ad-supported businesses," Wilson wrote in the note.
In the past, Netflix has made no mention of an ad-supported mode, and CEO Hastings has said talked about having three pricing plans for everyone. The company introduced an $11.99 streaming option last April.
Though much has been made about Netflix's content costs (it has $6 billion in off balance sheet liabilities), the company has a structural advantage in how it buys content. The company has detailed data on what each users watches, an on-demand schedule that caters to users, not Netflix itself, and it has the flexibility to buy differentiated content. "We believe this combination, along with Netflix's scale, allows the company to purchase content more efficiently than its traditional linear competitors and its smaller Internet competitors," Wilson noted.
Aside from being the dominant OTT player, Netflix's cost of content per hour viewed is substantially less than Comcast's, the largest cable operator in the U.S. Wilson estimates that Netflix pays just over 10 cents an hour viewed to get its streaming content, versus 23 cents an hour viewed for Comcast, and this gap is growing. This may be part of the reason why Comcast essentially forced Netflix to pay for direct access to Comcast's broadband network.
With Netflix's cost of content per hour viewed so cheap, the company can add more content, including original series such as House of Cards, Orange Is the New Black, and others. Last Friday, Netflix unveiled the trailer for the second season of Orange Is the New Black, a show about a woman's life in prison.
Netflix has an enormous opportunity to expand internationally, as developed countries in Europe present the next big area of growth for the company, and in a meaningful way. Netflix is likely to enter countries with 35 million to 55 million broadband households this year, which would not only allow it to remain profitable this year, but next year as well, as it continues its expansion. Wilson expects the country to expand into France in the second half of this year, with Germany, Italy, Spain and Turkey to follow. Recent media reports have suggested Netflix will launch in Germany in September of this year. By launching in these new countries, Netflix could add an additional 5 million international subscribers by next year, and 10 million by 2016, assuming Netflix sees the adoption rates it's already seen in European markets where it already has a presence.