Why Netflix Should Stay Domestic
Callum is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Netflix is all over the news, it's on your internet TV, there is an app for it on every conceivable device, and a considerable chunk of the US population has the service. But they need to refocus on their core market to ensure long term stability.
On Wednesday, Netflix (NASDAQ: NFLX) posted earnings that beat expectations, but were a sharp plunge from last year. Net income came in at 13 cents a share, or $7.68 million, versus the 4 cents expected. But the catch is that Netflix sees a rocky fourth quarter ahead, and its net income plunged from $62.46 million, or $1.16 a share, a year ago. For the fourth quarter, Netflix expects its net income coming in at a loss of 23 cents a share to a profit of 4 cents a share, versus the loss of 8 cents a share expected by analysts.
In second quarter, Netflix had 23.9 million US subscriptions. That grew by 1.2 million to 25.1 million in the third quarter, and management expects that to grow to 26.4 to 27.1 million subs by the end of the year, which would be a 20% increase in subscriptions this year (up from 21.7 million in the beginning of the year) and an increase of 1.3 to 2 million subscriptions in one quarter. International growth came in at 700,000 subs for the quarter, bumping the total number of international subs up to 4.3 million. Netflix sees that number jumping by 900,000 to 1.6 million in the next quarter to 5.2 to 5.9 million total international customers. One thing to keep in mind is that not all customers were paid; some of them were the 1 month free offering for both the domestic and international markets. For the domestic market, only 23.8 million were actual paid customers and only 3.7 million of international customers were paid customers, so when you see the subscription count go up, remember to watch out for those cheapo's who only want what's free.
Large costs for Small Growth
Netflix's core market is the US, and I think they should focus more on growing their sub base here than to try to expand in foreign countries, especially when they don't have a lot of money. The international markets make up only a small fraction of Netflix's total subscriptions, and haven't really paid off the way management had expected. With rising content costs and increasing amounts of competition from Amazon’s (NASDAQ: AMZN) Prime service (which recently acquired Epix's content that was previously only on Netflix) and other streaming content providers. Amazon Prime's user base has grown from 2 million in 2009 to almost 13 million as of the end of September (according to JPMorgan), which is impressive. Netflix needs to refocus itself and stick to a path that will lead to higher levels of growth and profitability. Just look at management's expectations for subscriptions growth in the fourth quarter; if growth (in users) comes in at the low end of their expectations, then 59% of that growth is domestic. If it comes in at the high end of their expectations, then 55.6% of that growth is domestic. Plus, for the third quarter 63.2% of that growth was from their domestic market (the US). Most of their growth is coming from the US, and they should be spending more on content to bolster their offering than trying to expand a weaker offering across several continents. Overall the international markets lost Netflix $92 million in the third quarter, while the domestic streaming service made them $91 million in profit and the domestic DVD service made them $131 million in profit. Had they not expanded into international markets, they would have made almost 1,300% more net income. Now to be fair, one could argue that this plan is for the long term and short term losses will mean long term gains in the years to come. But in my personal opinion, I think they should hold off on their international expansion for a while until they can offer a quality product that has a low churn rate with stable net income.
Netflix also needs to hold off on expansion until the can maintain stable margins. In Q4 2010, they had an operating margin of 13.2%, but by 2011 Q4 that was 8.1% and by 2012 Q4 it will be negative. This is a huge red flag for me, even for a growth stock like this. They have $5 billion worth of streaming liabilities, yet they only have $798 million cash on hand as of Q3. If they were to focus on offering a better product in the US (they could probably even slip in a small price increase once the Qwikster fiasco calms down), they could get higher levels of growth (in both EPS and customers) and actually hit their subscription growth estimates with enough cash to pay down their obligations and to get better content to draw in more clients.
Netflix offers a great service, but it needs to maintain a positive profit margin if it doesn’t want to default on its $5 billion streaming obligations. If it refocuses on the US market, then it could start to turn more of a profit, pay down its debts, and buy up more content to improve its offering in its biggest market. If Netflix does this, then expect good things from this stock. If it continues to expand recklessly into foreign markets, be careful, it could burn through its cash pile too quickly.
Know What You Own
The precipitous drop in Netflix shares since the summer of 2011 has caused many shareholders to lose hope. While the company's first mover status is often viewed as a competitive advantage, the opportunities in streaming media have brought some new, deep pocketed, rivals looking for their piece of a growing pie. Can Netflix fend off this burgeoning competition, and will its international growth aspirations really pay off? These kinds of issues are a must know for investors, which is why The Motley Fool released a brand new premium report on Netflix. Inside, you'll learn about the key opportunities and risks facing the company, as well as reasons to both buy and sell the stock. They’re also offering a full year of updates as key news hits, so make sure to click here and claim a copy today.
callumturcan has no positions in the stocks mentioned above. The Motley Fool owns shares of Netflix. Motley Fool newsletter services recommend Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.