Netflix, Inc. (NFLX) - Small Cap IR
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Netflix, Inc. (NFLX)
Rating: BUY
Good Long-Term Investment Despite High Valuation
RESEARCH REPORT:
PUBLISHED APRIL 23, 2014
If there is anything that is universal across the world, it is certainly people’s love of media content –
specifically movies and television. In fact, last year global movie ticket sales set a new record rising to
$35.9 billion. Considering nearly 70% of that total came from international markets outside the US, it is
safe to say that we are not the only ones enjoying our own movies. Although only up 5% from 2012,
international movie ticket sales are up 33% from five years ago. Meanwhile, ABI Research put out a
report earlier this year saying that worldwide pay-TV subscribers are expected to exceed 1.1 billion by
2019, aided by the help of the increasing internet protocol television (IPTV) segment.1 At the end of
2013, there were approximately 903.3 million pay-tv subscribers worldwide which generated nearly
$250 billion in service revenue. Separately, IPTV operators reported roughly 92 million subscribers
generating around $37 billion in service revenue. Although a CAGR of only 4% for the overall market is
not as impressive as the 18.5% YoY growth experienced in the IPTV operators alone (their CAGR is
expected to be closer to 10%), it clearly demonstrates increasing demand in general over the next
several years.2
Ultimately, when you are talking about a $300+ billion global market annually between movies and TV,
there is a significant push to grab every dollar you can from that market. One such company that has
revolutionized the movie and TV industry while continually growing its subscriber base is Netflix – a
company that nearly every person on Earth knows about and is easily identified by their bright red
envelopes.
Netflix, Inc. (NFLX) is an internet television network with more than 48 million members in over 40
countries across the world. The company operates in three segments: domestic streaming, international
streaming, and domestic DVD. Whereas the domestic and international streaming segments derive
revenues from monthly subscription services consisting solely of streaming content, the domestic DVD
segment (only available in the US) derives revenues from monthly subscription services consisting solely
of DVD-by-mail (which includes both regular DVDs and Blu-ray discs). The company also develops its own
content and original series, such as House of Cards and Orange is the New Black. Their core strategy is to
grow their streaming subscription business domestically and internationally while improving their
members’ experience by expanding streaming content and extending streaming service to even more
internet-connected devices.
REVOLUTIONIZING THE INDUSTRY:
Netflix has been – and continues to be – in the news a lot. Between winning content deals; calling out
Comcast’s merger with Time Warner Cable; activist investor participation (see: Carl Icahn); competition
with Amazon; raising subscription prices; the botched proposal to split the DVD and streaming
businesses in 2011; and volatility among the stock price performance (i.e. -78% drop in 2011 and
1
Netflix, Inc. (NFLX)
Rating: BUY
Good Long-Term Investment Despite High Valuation
subsequent 600% rise), one thing is clear – NFLX has received a lot of press. And rightfully so as the
company has single-handedly revolutionized the way we view and consume media content.
In just a few short years, Netflix has essentially done to movies and TV what Apple has managed to do to
music and cell phones – disrupt the industry and change the game. Nowadays, the term
“bingewatching” is associated with NFLX while nearly every internet-capable device must be Netflix-
capable as well. Internet streaming, on-demand, movies, and television are now all synonymous with
Netflix. When Blockbuster arrived on the scene in 1985, it changed the way we watched movies at
home. Now, less than 30 years later, Netflix has put Blockbuster out of business. While there is no
guarantee that NFLX will be around 30 years from today, the company has by no means reached its peak
and has plenty of room to grow for the foreseeable future.
As with any subscription-based service, NFLX is highly dependent upon existing and future subscribers
for current and future revenue. Out of the nearly 7 billion people on this Earth, only 48 million people
currently subscribe to NFLX. That is less than 0.7% of the worldwide population. Obviously NFLX is only
currently accessible to a small part of the world as internet access isn’t even available to certain areas
still. However, as internet access becomes more prevalent – aided significantly by the growth of mobile
– NFLX will inevitably follow in some areas. And while I’m not talking about NFLX having a billion
subscribers anytime soon if ever, the ability for the company to double its base is very probable –
especially when you consider the fact that HBO has about 130 million subscribers. Given both the
market size (in population and revenue potential) and that market’s thirst for media content, NFLX is
primed to quench that thirst over the coming years. Ultimately, with any stock, the growth potential is
what gets people excited. Couple that with real, growing and quality earnings and you have a recipe for
success.
SUBSCRIBER GROWTH:
Overall, in looking at NFLX’s subscriber growth, it is easy to see that while its domestic DVD segment has
been clearly declining, its streaming segments (both domestic and international) have been consistently
growing – at a fairly decent clip too.
Subscriber Growth 2013 2012
Domestic Streaming 23% 25%
International Streaming 79% 229%
Domestic DVD -16% -26%
Source: NFLX Form 10-K, December 31, 2013
Additionally, on a quarterly basis over the past two years, membership in domestic streaming has
increased on average by 5.4%, while international streaming has risen almost 20% QoQ. Meanwhile,
domestic DVD membership has decreased by about 5% on average each quarter.
2Netflix, Inc. (NFLX)
Rating: BUY
Good Long-Term Investment Despite High Valuation
June Sept Mar June Sept Dec Mar
30, 30, Dec 31, 31, 30, 30, 31, 31,
MEMBERSHIP GROWTH 2012 2012 2012 2013 2013 2013 2013 2014 AVG
5.43%
Domestic Streaming Member Growth 2.26% 4.86% 8.15% 7.47% 2.17% 4.31% 7.49% 6.74%
19.74%
Intl. Streaming Member Growth 18.24% 18.96% 41.99% 16.68% 8.47% 18.60% 18.96% 16.04%
-5.06%
Domestic DVD Member Growth -8.42% -6.86% -4.44% -2.93% -5.95% -4.79% -3.05% -4.01%
Source: NFLX Q1 14 Financial Statements, http://ir.netflix.com
Netflix also acknowledges that they suffer from seasonality issues as illustrated above, and as a result it
should be expected that subscriber growth in Q2 and Q3 of this year will likely be lower than the
previous two quarters. The company also recently stated that given the higher growth rates in the
international segment, seasonality there is less of an issue than in the domestic segment. Overall,
however, I expect the company to continue to grow at their longer-term averages as they continue to
add subscribers – especially in their international streaming segment.
It does appear that the company’s efforts to expand their international segment have worked well too.
The company recently announced that out of its current subscriber base of 48 million roughly 26% of
those subscribers are from outside the US – more than double the split just two years ago.
Mar 31, June 30, Sept 30, Dec 31, Mar 31, June 30, Sept 30, Dec 31, Mar 31,
Revenue Breakdown 2012 2012 2012 2012 2013 2013 2013 2013 2014
Domestic Streaming 88.4% 86.9% 85.3% 81.6% 80.3% 79.4% 77.2% 75.4% 73.8%
International Streaming 11.6% 13.1% 14.7% 18.4% 19.7% 20.6% 22.8% 24.6% 26.2%
Source: NFLX Q1 14 Financial Statements, http://ir.netflix.com
Growth in the international segment is expected to continue as the company recently announced its
intention to expand and launch in France and Germany. For now, however, the company’s presence is
mainly confined to the Western hemisphere (as illustrated below) and some European countries.
Considering the company’s first foray into the international markets began only in September 2010,
NFLX has made considerable progress overseas, and should continue to do so in the future.
3Netflix, Inc. (NFLX)
Rating: BUY
Good Long-Term Investment Despite High Valuation
NOTE: Countries where Netflix is currently available are highlighted in red. Source:
bestofnetflix.com, July 2013
EARNINGS QUALITY:
While there are many analysts and investors who argue that the company’s growth in international
markets is a reason to invest in the company, one of the biggest criticisms of NFLX has been the fact that
its international segment continues to operate at a loss. While that is certainly true, the company has
been making tremendous strides in turning that segment around and even expects to achieve
profitability this year. Given the improving performance of the international segment over the last
several quarters, I believe that is highly likely.
In fact, just two years ago, the international streaming segment was operating at a -236% operating
margin compared to only -13% this past quarter. That’s quite an improvement over just two short years.
Moreover, margins in the domestic streaming segment have improved as well over the past two years
rising from about 14% at the end of March 2012 to 25% in March 2014. Meanwhile, the domestic DVD
segment has even slightly improved over the same time period and most recently posted margins in-line
with its quarterly average of roughly 48%. So, yes, the international segment is still losing money, but it
is losing significantly less money than it has in the past AND it should post a profit in the near future.
Mar 31, June 30, Sept 30, Dec 31, Mar 31, June 30, Sept 30, Dec 31, Mar 31,
AVG
OPERATING MARGIN 2012 2012 2012 2012 2013 2013 2013 2013 2014
20.30%
Domestic Streaming 14.31% 16.41% 17.21% 19.24% 20.57% 22.55% 23.75% 23.44% 25.20%
-85.50%
Intl. Streaming -236.46% -137.64% -118.82% -103.21% -54.16% -39.68% -40.59% -25.87% -13.10%
5.70%
Total Streaming -5.49% -0.34% 0.53% 1.27% 6.97% 10.21% 10.43% 12.09% 15.60%
47.87%
Domestic DVD 45.71% 45.90% 48.16% 50.14% 46.65% 46.74% 48.09% 51.67% 47.73%
Source: NFLX Q1 14 Financial Statements, http://ir.netflix.com
4Netflix, Inc. (NFLX)
Rating: BUY
Good Long-Term Investment Despite High Valuation
Furthermore, in breaking down the three segments by revenue, costs of revenues, and marketing costs
over the past three years, there are several things to note. First, international streaming revenues have
been growing by over 100% the past two years, while increases in content costs have been slowing
(from 80% to 39%) over the same time period. Further, although marketing costs jumped in 2012 (in the
international segment), they seemed to have stabilized across all segments in 2013. Moreover, domestic
streaming revenues continued to rise while costs were fairly stable. Only in the domestic DVD segment
did revenues decline as subscriber growth has been negative the last few years due to the rising
popularity of streaming. This decline, however, was met by a similar decrease in costs. Overall, I believe
the trends displayed below are positive for the company going forward and should help drive earnings
quality in the future.
Revenues 2013 2012 2011
Domestic Streaming 63% 61% 54%
Intl Streaming 16% 8% 3%
Domestic DVD 21% 31% 42%
Costs of Revenues 2013 2012 2011
Domestic Streaming 60% 59% 60%
Intl Streaming 25% 18% 10%
Domestic DVD 15% 23% 30%
Marketing Costs 2013 2012 2011
Domestic Streaming 55% 55% 68%
Intl Streaming 42% 43% 30%
Domestic DVD 2% 2% 1%
Source: NFLX Form 10-K, December 31, 2013
CONTENT COSTS:
Without a doubt the company’s largest expenditure (as expected) has, and will continue to be, the
expansion of its content library. Rising content costs (both through licensing and NFLX’s own original
programming) are the most important factors affecting the company’s overall profitability.
5Netflix, Inc. (NFLX)
Rating: BUY
Good Long-Term Investment Despite High Valuation
Although somewhat volatile over the years (and recent quarters), overall the costs of content growth
have only slightly outpaced that of revenue growth on average. However, it does appear that the
company has gotten better at managing those costs while growing revenue at a meaningful pace. It is
my belief that the company will only get better over time and the trend indicated below is relatively
optimistic for NFLX going forward.
ANNUAL
34.78% 46.19% 20.86% 13.28% 22.34% 29.52% 48.17% 12.61% 21.22% 27.66%
68.48% 34.84% 25.36% 15.78% 18.57% 25.76% 50.33% 28.73% 17.40% 31.69%
2005-12 2006-12 2007-12 2008-12 2009-12 2010-12 2011-12 2012-12 2013-12 AVG
Revenue Growth
Costs of Content Growth
QUARTERLY
6.57% -0.68% 2.18% 1.80% 4.42% 8.36% 4.39% 3.46% 6.24% 8.09% 4.48%
7.08% 8.52% 3.04% 3.11% 4.98% 4.45% 3.71% 4.91% 2.65% 7.02% 4.95%
2011-12 2012-03 2012-06 2012-09 2012-12 2013-03 2013-06 2013-09 2013-12 2014-03 AVG
Revenue Growth
Costs of Content Growth
Source: Morningstar
VALUATION:
I do hate the expression “priced for perfection” and perhaps that may be the case with NFLX at current
valuations, but considering historical valuations, the stock isn’t as expensive as it has been in the past.
More importantly, NFLX is somewhat different from other stocks when looking at it on a valuation basis.
As with most technology stocks, valuations often do get out of control and it is tough to really value a
company that trades at a P/E of around 200. Compared to its normalized ratios, NFLX does indeed
appear to be overvalued at current levels. However, following both the optimistic earnings release on
Monday afternoon and the nearly 20% drop in the stock’s price over the past 6 weeks or so, I do believe
the company will push higher from these levels of around $350/share.
6Netflix, Inc. (NFLX)
Rating: BUY
Good Long-Term Investment Despite High Valuation
Furthermore, using today’s closing price of $353.50 and growing revenue, earnings, and EBITDA at the
company’s 10-year average growth rates, NFLX’s valuation looks more reasonable (and investable). Sure,
there are risks to proper execution by the company as well as a still-expensive valuation 18 months out,
but when you look at the historical valuations and the company’s potential growth in revenue, earnings,
and EBITDA, the company is somewhat attractive. Lastly, it does bode well for the stock as the
enterprise value (EV) of the company (especially a technology company) is currently trading at less than
6x this year’s EBITDA. It is important to realize, however, that this is due primarily to the company’s high
amortization expenses tied to the company’s content library.
OTHER ISSUES:
As mentioned earlier, NFLX is heavily dependent upon the media content they currently have the rights
to as well as their ability to purchase future rights to media content at reasonable prices. The company is
also heavily dependent on the technology customers utilize to access NFLX’s online library, as well as the
internet broadband capabilities of their customer’s internet service providers (ISPs). Further,
government regulations and net neutrality laws may threaten NFLX’s business model in the future.
Moreover, given NFLX’s increasing expansion into international markets, there are additional economic,
political, and regulatory risks that the company may face. These risks extend beyond the different laws
and specifics regarding certain content licenses and adoption to include foreign currency exchange risks,
adverse tax consequences in other countries, different user/data protection and privacy laws, low
usage/penetration of internet connected devices, and the availability of reliable broadband connectivity
for expansion.
Additionally, although competition is fierce – especially between NFLX and Amazon Prime – having one
service doesn’t necessarily mean you cannot have the other. To me, NFLX and AMZN are sort of like
movie studios that compete with each other, but still make money by offering different movies. In this
case, the “movies” are the various movie/TV content that available on each platform. Further, NFLX is
offered on all the various internet-connected devices such as Apple TV, Roku, and even the
newlyintroduced Amazon TV. Further, the news today concerning the agreement between Amazon and
HBO should not affect Netflix’s business as much as the market would have you believe given the 5%
sell-off as a result. Investors in NFLX should be aware of dramatic price swings such as these following
7Netflix, Inc. (NFLX)
Rating: BUY
Good Long-Term Investment Despite High Valuation
news surrounding content licensing deals as shares are known to be volatile (in both directions) during
these times.
Lastly, while some investors and analysts are wary of NFLX’s recent decision to raise prices $1-2/month, I
believe the price increase will not affect subscriber growth all that much. Although some people may be
more hesitant to sign up for $8.99 (or $9.99) per month instead of the current $7.99 per month price, as
long as the price doesn’t go over the psychologically-important $10 level, new adds will remain
competitive. It should also be noted that even a $2 increase per month is the same 25% price increase
that new subscribers to Amazon Prime’s service were just hit with recently (increasing from $79/yr to
$99/yr). Further, I would not be surprised if this quarter saw an increase in new subscribers who wanted
to avoid the impending price increase as those members will not experience a price increase for a
“generous amount of time” per NFLX management.
CONCLUSION:
Ultimately, the tremendous growth potential both here in the US and abroad is significant and should
further propel the stock higher. In the near-term, performance is likely to be volatile – mostly due to
general market factors and the “guilt-by-association” mentality that has plagued the momentum names
(see: TSLA, CMG, FB, etc.) as of late. Over the longer-term, however, I believe NFLX will continue to do
well as they better manage their content costs and continue to grow subscribers. While I definitely
would prefer a lower current valuation, the recent 20% correction in shares of NFLX makes it a more
compelling buy at these levels. In the end, it is tough to bet against the pioneer in an industry (see:
Apple) – especially one that has proven it can execute well on a consistent basis.
Sources:
1 ABI Research. “Worldwide Pay-TV Subscribers to Exceed 1.1 Billion in 2019 with Increasing IPTV Market
Share.” 22 January 2014.
2 Ibid.
8Netflix, Inc. (NFLX)
Rating: BUY
Good Long-Term Investment Despite High Valuation
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not receiving compensation for it, and I have no business relationship with
any company whose stock is mentioned in the article.
The information contained herein is not intended to be investment advice and does not constitute any form of invitation or
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which may cause the actual results, performance or achievements of mentioned company to be materially different from the
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