Netflix Demonstrates Strong Performance; Stock Remains Richly Valued


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Netflix's ( NFLX ) stock touched an all time high of $390 as the company's Q3 2013 earnings beat consensus estimates, before falling back to its current levels on concerns raised by some analysts and billionaire investor Carl Icahn's disclosure of selling his stake in the company. The primary reason behind the market's exuberance seems to be Netflix's sustained subscriber growth accompanied by improving margins. While the DVD declines continued, Netflix gained 2.73 million net subscribers in its streaming business globally in the third quarter. The content advantage is playing a big role and there seems to be a halo effect of some of the key original series that the company has acquired in recent quarters. We have increased our price estimate for Netflix by 40% to $232 in the light of recent earnings. However, our estimate still stands 30% below the market price as we believe that the market's reaction is overdone and certain risks are being overlooked. Let's take a quick look at why we have increased our price estimate and why we are still below the market price.

See our complete analysis for Netflix

Our Top Forecast Changes

Our most significant forecast changes include increasing the domestic and international streaming contribution margins, reducing technology and development expenses, and increasing the domestic streaming subscriber count.

We now expect domestic streaming contribution margin to reach close to 36% by the end of our forecast period compared to our earlier expectation of 31%. Additionally, we have increased the forecast for international streaming contribution margin from 30% to 34%. These forecast changes added roughly 20% to our price estimate.

Netflix's technology & development costs as a percentage of revenues, which saw a jump in recent years, seem to be coming down in 2013. Given that the company is gaining operating leverage due to continued subscriber gain and consolidation in international markets, we have reduced our forecast for these expenses from 9.1% to 6.6%, which added roughly 10% to our price estimate. Additionally, we now expect Netflix's domestic streaming subscriber base to reach close to 54 million by the end of our forecast period, against our previous expectations of 49 million, thereby adding another 5%-6% to our price estimate.

Why Did We Make These Changes?

Domestic Business

While we believe that the market is pricing Netflix too steeply, the third quarter results did carry certain merit. The company demonstrated its ability to sustain subscriber growth in the near term. Given the fixed nature of content costs, revenue growth is directly impacting the company's margins, which appear to be on track to grow by 400 basis points this year. Netflix has a significant content advantage and plans to invest more in original programming next year. In addition, it is actively looking to explore developing its own movies and documentaries, thus strengthening its control over the content supply. As a result, we have increased our forecast for the number of domestic streaming subscribers as well as domestic streaming contribution margins.

Netflix has been making concerted efforts to differentiate its streaming content and the launch of original series such as Arrested Development and House of Cards has fueled subscriber growth this year . The company 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.

International Business

Netflix gained 1.44 million net subscribers in international markets in the third quarter, reducing its contribution loss by roughly 20%. At the same time, revenues jumped by 135% due to continued expansion in Europe, Canada and South America. The company expects its profitability to increase in the fourth quarter, and this change would be more visible next year as it consolidates its position in Europe. The adoption of the service has been encouraging despite the competition from Lovefilm in Europe. We have increased our forecast for the the number international subscribers as well as international contribution margins.

Why Is Caution Warranted?

The third quarter results should be taken with a pinch of salt due to soft comparison against weak Q3 2012. Besides, the market seems to be ignoring the risk that is inherent in Netflix's business model. Most of the company's content costs are fixed in nature. Its target of expanding margins by 400 basis points annually will only work if it is able to maintain the rate of 6 million net domestic subscriber additions every year. That seems to be a long shot given that by the end of this year, Netflix will cover close to one-third of U.S. households and its growth is bound to slow down. As the growth decline, so will the rate of increase of its margins. This will result in content costs catching up and weighing on profits.

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 (the figure for Q3 is not available yet). The jump in the second quarter was significant and growing competition can be a cause for concern. Amazon ( 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.

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Streaming Content Costs as % of Revenue





Total Content Costs as % of Revenue





Streaming Content Obligations as % of Revenue




Total Streaming Content Obligations ($ Million)




The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Investing Ideas , Stocks , US Markets
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