Netflix: Firing On All Cylinders

Ishfaque is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Online video streaming giant Netflix (NASDAQ: NFLX) is always full of surprises, whether it’s fending off activist investors or suddenly raising prices 60%. The company surpassed its most recent sell-side EPS estimates by a huge margin, and shares are up roughly 70% after its latest earnings. In addition to silencing a lot of naysayers, the firm answered a lot of key questions regarding its future strategies. Alongside more surprises, the company has a rock-solid future ahead. 

Strong growth across the board

Netflix’s Q4 numbers were extremely impressive all around. The company now has more than 33.3 million global streaming members. In Q4, it added 2.05 million new subscriptions in the U.S. and 1.81m subscriptions in International markets. 

Revenues are up 7.4% Y/Y to end at $945 million, and the company rolled out an unexpected profit of 8 milion. Also, the contribution margin in the U.S. was up by 2.1% to hit 18.5%. The DVD business continues to scale down, but at a lower-than-expected rate. However, margins in the DVD business will take a hit from the increased USPS mailing rate of $0.01 each way, which went into effect earlier this month. 

Increased tablet and smart TV adoption 

Increased tablet and smart TV adoption during the holidays provided additional tailwind for subscriber growth. As manufacturers place more and more Netflix buttons on smart TVs, the service's subscription additions get a big boost. High customer satisfaction led to more word-of-mouth marketing, which aided in trimming down the company's marketing budget. In addition to its low cost, Netflix’s ubiquitous accessibility is also a big value proposition for the company. Deeper integration with gaming consoles, Smart TVs and Blu-ray players gives Netflix access to millions of new households worldwide.  

The 'virtuous cycle' has been paying off

Netflix's business can be summed up as, "Add content, bring in subscribers and revenues, and use the incremental content budget to purchase more content." This business model has been paying off for Netflix thus far, and the company now has nearly 3 million free users in the pipeline, ready to be converted to paying customers in the next quarter

Netflix's mega deal with Disney (NYSE: DIS) doesn't go into effect before 2016, and in the interim, the company continues to license more content. Even though Disney content represented only 2% of Netflix's existing viewership, the addition of titles from big studios like Disney, Pixar, and Marvel will be a huge boost for the company going forward. Netflix also struck a deal with Time Warner (NYSE: TWX) subsidiary Warner Bros., the largest TV producer in the world, and will add a lot of popular TV shows to its content library. 

Service differentiation with original content

Netflix is diving into original content, and will be rolling out a number of shows globally throughout 2013. Even though investing in original content may seem like a gamble, success with originals will lead to the production of more original content, and more importantly, enhance Netflix’s global brand value.

The main value of original content comes from its ability to bring in new subscribers and keep the existing ones very satisfied. As the original content will be completely exclusive to Netflix, it will serve as a strong value proposition for potential subscribers.  

Competitive threats are overblown

Coinstar (NASDAQ: CSTR)- and Verizon-powered Redbox Instant is in beta testing, and hasn't seen a major launch yet. But it will appeal to the end-user, since it comes at a similar price point as Netflix, and also allows users to pick up DVDs from the almost 30,000 locations of Redbox kiosks. Another major player is Time Warner's HBO Go; it offers a great user experience, but its price point is much higher, as it is bundled with an HBO subscription.

Amazon (NASDAQ: AMZN) is building out original content, and so is Disney-backed Hulu. The more original content the competitors have, the more different their services become from Netflix. Amazon has a lot of cash to fund many original programs, and can market them through its Amazon Instant, Prime, and LOVEFiLM programs.  

Netflix conducted a study to determine competition and how much of overlapping content was available between the main players in the online streaming business. The most popular 200 titles (top 100 TV shows and top 100 movies) on Netflix were examined, and they revealed a picture markedly different from what investors initially assumed.

Netflix Top 200 (100 TV shows + 100 Movies) and the Overlap With: 

Amazon Prime: 73 titles

Hulu Plus: 27 titles

Redbox Instant: 12 titles

Overlap is significantly lower than initially expected, as a result, the threat of substitute offerings is much lower, making competitive forces are a lot weaker than initially suspected.

International losses will narrow in 2013

With the launch of the Nordic market, Netflix now has more than 6 million international subscribers, and losses are expected to narrow over the next few quarters. Management is keen to invest heavily overseas in the roll-out of new content, and expand in international markets in the second half of 2013 and 2014. Netflix is ahead of leading competitors, in terms of viewership and sales in the International marketplace as well.

The addressable market share in the Latin America region is huge, as more than 50 million households have broadband connections. Netflix is working on its payment collections in the region, which will boost member additions going forward, particularly in Mexico and Brazil. 

Better user experience

Changes to the Video Privacy Protection Act (VPPA) resulted in users being able to share their playlists with their friends on social media platforms. This will lead to a better Netflix experience for many users. Also, tailored recommendations based on viewer trends in the Netflix ecosystem also leads to a better user experience.

Netflix is testing for a broad roll-out of individual user profiles that will make recommendations, based on the taste of each user in the household. Increased spending on content is attracting newer subscribers and keeping existing customers satisfied. Satisfaction with a wider content library is driving down the voluntary churn rate -- in other words, users' voluntary cancellations. 

The takeaway

Netflix's addressable market remains huge; management estimates its size at roughly 60 million-90 million users. The company is funding a lot of original content, and as a result, its free cash flow will be negative for the next few quarters; after that, it could improve by a big margin. The outsized growth trajectory of Netflix will lead to a bigger premium valuation to the overall market going forward, but an investment here is not for the faint-hearted.

ishfaque has no position in any stocks mentioned. The Motley Fool recommends, Netflix, and Walt Disney. The Motley Fool owns shares of, Netflix, and Walt Disney. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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