Netflix (NFLX, Financial) is the world’s leading Internet television network with over 57 million streaming members in nearly 50 countries. Netflix is a pioneer in the Internet delivery of TV shows and movies, launching the streaming service in 2007. Prior to July 2011, in the U.S., the streaming and DVD-by-mail operations were combined and members could receive both streaming content and DVDs under a single “hybrid” plan. In July 2011, the company separated the combined plans, making it necessary for members who wish to receive both DVDs-by-mail and streaming content to have two separate membership plans.
Business Revenue Segment:
Netflix has three modes of earnings:
1) Domestic Streaming Segment
2) International Streaming Segment
3) Domestic DVD Segment
Domestic Streaming Segment: In the Domestic streaming segment, Netflix derives revenues from monthly membership fees for services consisting solely of streaming content offered through a membership plan. The increase in the domestic streaming revenues was due to the 22% growth in the average number of paid memberships, as well as to the 2% increase in average monthly revenue per paying member resulting from the price increase for new members in the second quarter of 2014.
International Streaming Segment: In the International streaming segment, Netflix derives revenues from monthly membership fees for services consisting solely of streaming content offered through a membership plan. The company launched the streaming service in Canada in September 2010 and have continuously expanded services internationally with launches in Latin America in September 2011, the U.K. and Ireland in January 2012, Finland, Denmark, Sweden and Norway in October 2012, the Netherlands in September 2013, and Germany, Austria, Switzerland, France, Belgium and Luxembourg in September 2014. In the first quarter of 2015, Netflix expects to launch the service in Australia and New Zealand. Later in the year, it expects to launch additional major countries, in keeping with the global strategy.
The increase in international revenues was primarily due to the 82% growth in the average number of paid international memberships as well as the 1% increase in average monthly revenue per paying member resulting from the price increase on the most popular streaming plan and the introduction of the premium plan, offset partially by the impact of exchange rate fluctuations. Average paid international streaming memberships account for 27% of total average paid streaming memberships as of December 31, 2014
Domestic DVD Segment: In the Domestic DVD segment, Netflix derives revenues from the DVD-by-mail membership services. The price per plan for DVD-by-mail varies from $4.99 to $43.99 per month according to the plan chosen by the member. DVD-by-mail plans differ by the number of DVDs that a member may have out at any given point. Members electing access to high definition Blu-ray discs, in addition to standard definition DVDs, pay a surcharge ranging from $2 to $4 per month for the most popular plans.
The decrease in the domestic DVD revenues was due to a 16% decrease in the average number of paid memberships. The decrease in domestic DVD cost of revenues was primarily due to a $16.0 million decrease in content expenses and a $43.0 million decrease in delivery expenses resulting from a 22% decrease in the number of DVDs mailed to members.
Outlook:
There is a dispute between the bulls and bears which really come down to four things:
1. Market opportunity
2. International expansion
3. Volume / user growth vs. price wars
Market opportunity:
The CEO is targeting paid streaming subscribers of around 60-90M domestically vs. 37.7M currently and 39.79M guided for 1Q15. Statista identified the number of "Connected TV sets" at 400M worldwide as of 2014, and sees this figure increasing to 487M by next year and 760M by 2018.
While not all paid users will use a television to watch NFLX shows, I could use this as a baseline, as most users will have a subscription for the TV and may or may not use their mobile devices for on-the-go access. This is, we think, a reasonable assumption going forward. And so, if I take NFLX's paid streaming subscribers, we see an increasing attach rate to connected TVs over time.
To confirm the above cited, I came with an example that would show more accurately what the market penetration rate might actually be. One example that comes to mind is the DVR market. DVR services have the advantage of recording live TV in real time, as opposed to the show releases from providers like HBO, NFLX, Hulu, and AMZN Prime Video. However, DVR is not able to get these shows from the providers, prompting an issue for users. At one time, DVR was a hot item, and it still exhibits strong growth internationally.
However, the domestic market is maturing and will likely to shift toward the new technology that is cloud-based DVR subscriptions over gateways, and despite hardware costs going down, providers can obtain higher margins over time by switching to a cloud-based service.
An estimate from IDC in the U.S. revealed that DVR services reached at its growth peak in 2009 and will level off from a penetration-rate perspective from here on. As shown below, the penetration rate is expected to reach just 45% by 2017, which I believe digital streaming can likely outpace due to consumption methods and lower price for service.
The point here is that saturation will occur around the 50% level in the domestic DVR market, which means that if NFLX is successful in taking the market from AMZN, HBO, and other streaming media companies, they can get to about a 50% household penetration rate domestically. That's what's in play.
In the contemporary time there is a difference in markets of media streaming and DVR services, consumption by 50% of a market is pretty astounding. As seen in the above diagram an investor can easily deduced that penetration rate reaching that 50% level somewhere around 2018.
After considering the above scenario, it can be deduced that Netflix will get around 60-90M users.
International - Big Deal or Bad Deal?
Netflix is building out its service internationally, especially at the time when it is being projected that Netflix achieved a mature penetration rate domestically in the medium term. In the long run, international expansion provides a new revenue stream, though at this point, it is more important that it significantly impacts projected margins and earnings. In the last quarter, management said:
They have launched our streaming service in Canada in September 2010 and have continuously expanded our services internationally with launches in Latin America in September 2011, the U.K. and Ireland in January 2012, Finland, Denmark, Sweden and Norway in October 2012, the Netherlands in September 2013, and Germany, Austria, Switzerland, France, Belgium and Luxembourg in September 2014. In the first quarter of 2015, we expect to launch our service in Australia and New Zealand. Later in the year, we expect to launch additional major countries, in keeping with our global strategy.
As International grows more quickly, it will weigh on margins as the profile overseas is not built out enough and requires more investments. This can impact revenue due to FX, and may face regulatory hurdles in various countries.
Even though Netflix now has its presence in international markets, I estimate that the international segment may not be profitable for quite some time - in fact not until FY17 on an annualized basis. While bears may want to point to a possibly longer-time frame, the leverage from FY13-14 in the International arena was quite remarkable.
On the positive side, Netflix is growing its international base and will likely continue to do so. However, as they grow this business faster than the domestic market, it will create operating margin headwinds and may weigh on earnings for quite some time, depending on the level of investments needed to obtain the growth needed for long-term success.
There are a lot of uncertainties here, and we think the bears might win out as regards near-term international prospects.
Volume Growth
In most of the coverage, I always focus on the volume growth, and in this case, paid user growth (total user growth - i.e., including non-paid - shouldn't matter as that doesn't generate revenue and is only a lead indicator). Much of the debate over the last few years, however, has been on its attempt to raise prices.
For example, in 2011, Netflix got plenty of negative feedback both from a customer satisfaction and stock price point of view as it attempted to raise prices 60%. The stock raced lower by almost 70% in July 2011 as concerns of volume growth weighed on the stock. However, the company is passing on a $1/mo. price increase to new subscribers, which should provide an avenue of growth, but may mute the amount of user growth estimated.
One key metric we are looking at is bookings/billings, which is defined as revenue plus the change in deferred revenue. By tracking this and not just revenue, we can track the amount of contracts with customers that have a piece of it deferred for future collection as it rolls off the balance sheet. Bookings here takes into account both revenue and future revenue. As you can see below, 2012-2014 actually saw a large uptick in bookings growth - though we do not believe Netflix can sustain this amount barring major success internationally.
The second metric we track is, of course, price per month domestically, internationally, and in the domestic DVD business, which is in secular decline. We note that we factored in the price increase for new members already for 2015 in our numbers.
Notice two things here. First, DVD subscriptions actually are priced higher as it encourages users to roll into the streaming service and in order to cover the costs for the DVD business. Second, prices have come way down from the 2011 peak. We have this business at a -25% Y/Y clip on a revenue basis as this is a mature business that NFLX is slowly rotating out of. However, this will hit margins given the 48% contribution margin it provides and continue to hinder earnings in a transition to streaming over DVDs.
NFLX will not be able to continuously raise prices as the service becomes commoditized by the industry. While NFLX can likely raise prices a few dollars further, it has to be mindful of other service providers that have arguably similar content (think Game of Thrones with HBO vs. House of Cards with NFLX). HBO is already looking to make sure their volume dominance is maintained and will itself likely try to make its $15/mo. service cheaper to weed out the competition. On top of HBO, other service providers are looking at monthly content streaming services that would directly compete with NFLX. NFLX lacks the ability to keep market entrants out, which gets us to our main final point of contention
Valuation:
Many firms at Wall Street valuing the company share ranging from $245-$600 over the next twelve months. But as per one of the contributor “Value Play” the Netflix is currently valuing at $475 with a risk-reward of $415-$538. They arrive here on 3 different methods and taking the average of them.
First, in DCF they assumed a 4x sales terminal value in FY18 which equates to $46B. We also expect content investments, the transition to more international members’ growth weighing on margins, business loss of the DVD margin, and international build out itself to weigh on cash flow. With a recent$1.5B debt raise, NFLX is well off to burn cash in the short-term, however, this will weigh on EPS
Second, shares are trading at 5x trailing sales. We believe this is a bit of a premium to where it will trade from a fair value perspective as the company's growth will likely slow in 2015 and the average multiple is not this high. They use 4.5x 2015's sales on our P/S method.
Finally, they use a modified PEG where we use the earnings CAGR over the next few years to arrive at an appropriate P/E multiple. They assume that a 2.0x PEG makes a stock 'fairly valued', and thus in our out year valuation, they arrived at a P/E of 45x, which is well-below the current 105x trailing EPS. This would factor in what we discuss above already.
While their range is wide, the stock is clearly highly volatile and dependent on the aforementioned 4 key debates. Their base case just doesn't provide enough return (gain < WACC) to get behind the stock at this point with the recent run up in shares.
Post expounding it is believe that more patient investors should wait for another dip in order to trade the stock looking at the volatility it’s not advisable to hold the stock for long term.
Disclosure:
I don't have any investment in the aforementioned stock, nor do I get paid from the aforementioned stock company to write, and I have no plans to invest in the stock for the next 72 hours.
The above details are taken from the company filings 10K and a report of Value Play organisation is considered to draft this article.
The above pictures are taken from the Value Play report on Netflix.
