When Netflix's (
) stock fell in the after-hours trading after the company
disappointed with its Q3 2012 results, no one thought that it would
bounce back by 40% over the next 1.5 months. At that time, we
price estimate to $81
, indicating significant upside potential as we felt the market had
punished Netflix's shares a bit harshly. Profits were definitely
being squeezed in the short term, but Netflix's content and brand
advantage were being underestimated.
With the disclosure that investor Carl Icahn's firm took a 10%
stake in Netflix and the company's recent exclusive deal for
Disney's movies where it beat out some larger pay-TV networks, the
stock has soared.
Our price estimate now stands at a discount of about
to the market price, indicating that Netflix may not have
much room to grow from here unless it significantly changes
the way it pays for its content or gets acquired by a company with
deeper pockets. Although we do believe that subscriber growth will
continue both in the U.S. and international markets, there are
certain risks that may impact Netflix's profitability. Below are
some of the key issues we feel are critical to Netflix's
See our complete analysis for Netflix
Subscriber Growth Slowing Down In The U.S. - How Much Can
Netflix enjoyed high subscriber growth until mid-2011. The
company revolutionized the movie rental industry when instead of
having to drive down to a rental store, customers could get DVDs
right at their homes without having to pay for postage. This proved
to be a significant advantage as Netflix grew its subscriber base
from 1.5 million in 2003 to close to 12.3 million in 2009. In 2009,
the explosive growth began and Netflix expanded its base from 12.3
million to 24.4 million subscribers within a span of two years. The
reason for this growth was a significant push into streaming, which
was initially added as a free add-on service for DVD subscribers
and later became Netflix's mainstream offering.
However, following its decision to increase the prices of hybrid
plans by 60% in 2011, Netflix's subscriber growth trajectory
changed. The company lost subscribers in Q3 2011 for the first time
in years, which sent the stock plunging.
Although Netflix seems to have recovered from that slump,
subscribers are not growing as quickly as they did before. During
its Q3 2012 earnings release, the company lowered its domestic
subscriber guidance for the full year from 7 million to 5 million.
DVD subscriber losses continue although most of them are converting
into streaming-only subscribers. While we expect Netflix's U.S.
streaming subscribers to increase from 22 million in 2011 to close
to 40 million by the end of our forecast period, we expect DVD
subscribers to decline from 11 million to 5 million during the same
period. It must be noted that DVD rental is a higher margin
business compared to online streaming.
We have incorporated these expectations into our pricing model
and believe that higher growth in the U.S. is unlikely given the
First Mover Advantage Is There, But Competition Is
There is no doubt that Netflix still has the content advantage
over its competitors and the closest match perhaps would be Amazon,
which is still far behind. Besides its regular deals, Netflix is
also spending a notable portion of its content budget on original
programming. The company furthered its content advantage with a
landmark deal with Disney (
) recently, where it grabbed exclusive rights for Disney's newly
released movies. Netflix will make them available to its
subscribers as soon as 7 months after their theatrical release.
Amazon doesn't have such deals, and Netflix actually snatched this
contract from Starz, which is a premium pay-TV network. The
company's commitment towards content improvement is commendable,
but that comes with high costs.
Netflix's first mover advantage has brought it this far, but
competition is growing from big giants. Amazon offers streaming
bundled with its Amazon prime service. According to Bloomberg,
Amazon Prime had between 3 million and 5 million subscribers in
October 2011 and was planning to increase this count to 7 to 10
million subscribers by the end of 2012 or mid of 2013.
Amazon had over 22,000 titles in its streaming library in August
2012, representing 70% growth in 2012 alone. The company further
signed a deal with Epix in September to add 3,000 more titles to
its library, bringing the total count to 25,000.
It appears that Amazon Prime's subscriber base and content growth
is sufficiently large to cause concern for Netflix.
In addition to this, while Comcast (
) and Dish Network (
) are nurturing their own streaming services, Verizon (
) and Redbox are partnering to launch
. What's surprising is that almost all of these services are priced
lower than that of Netflix. These big giants are using streaming as
a way to promote their primary business and hence are charging less
to customers. This could prove dangerous for Netflix.
Content Costs Are The Biggest Concern
Netflix's content acquisition costs (as % of revenues) have
increased from 14% in 2010 to an estimated 44% in 2012. This huge
jump can be attributed to Netflix's international expansion as well
as its foray into original programming. However, we cannot deny
that Netflix will need to continuously improve its content given
that customers may be willing to end their subscriptions once they
have cycled through it. While making the entire content available
at once to subscribers is an advantage, it also poses a challenge
for Netflix in terms of keeping subscribers interested. We expect
content costs to increase further in the future and put pressure on
Netflix's margins. Even though content obligations have stabilized
in the past two quarters, the recent expensive deal with Disney
suggests that they could increase further (see What Are The
Implications Of Netflix's Deal With Disney?)
International Growth Provides Support
Not all is gloomy for Netflix. The company has been aggressive
with its international expansion. Following its debut in Canada, it
has expanded to Latin America, The U.K., Ireland, Norway, Denmark,
Finland and Sweden. Netflix had already gained more than 4 million
subscribers internationally by the end of Q3 2012. Latin America
has been little slow primarily due to payment issues as many people
don't have credit cards and several debit cards are not approved
for online transactions. However, this issue should resolve slowly
and the market is still lucrative from a long-term perspective.
Netflix has spent a lot upfront in getting content deals tailored
to these international markets. While this is resulting in
near-term losses, subscriber growth will lead to profits due to the
fixed nature of Netflix's content costs. Over the long term,
international markets have the potential boost Netflix's cash flow
growth provided the company can acquire enough subscribers.
Our price estimate for Netflix stands at $81, implying a
discount of little over 5% to the market price.
How a Company's Products Impact its Stock Price at