Netflix Has Solid Upside

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

Netflix's (NASDAQ: NFLX) has been a solid performer in 2013 so far. With such a strong showing under its belt, many investors have become skeptical of Netflix's upside potential. However, the company's business model has undergone a material change, and has now evolved into being a content producer, in addition to being a video-distributor. With strong subscriber additions, along with narrowed losses from overseas, Netflix has substantial room to run.  

Domestic market can gain further

The rapidly growing Netflix added more than 3 million streaming subs across the globe in 1Q13, and surpassed the 36 million subscriber mark. Netflix had 74 overlapping titles with Amazon for the top 200 titles, which is pretty much flat from 4Q12. Netflix’s top line revenue grew to $1.024 billion for 1Q13.  

Investors have been overjoyed about Netflix's domestic operations lately. Netflix’s domestic subscriber base saw a healthy increase of more than 2.03 million in Q1 2013, bringing the total U.S. sub base to more than 29.17 million, of which 27.91 million are paying subscribers. The domestic contribution margin of Netflix has seen solid increases in each of the last 5 quarters. The domestic contribution margin stood at 14.3% in Q1 F’12 and increased to 20.6% in 1Q13, which represents a 140 bps increase from the previous sequential quarter.

The continuous expansion in contribution margin increases shows that Netflix is substantially benefiting from economies of scale, as its business operations in the U.S. market gets bigger. Netflix’s management is expecting the target contribution margin ramp of 100bps each quarter.

According to SNL Kagan, Netflix had surpassed the subscriber base of Time Warner's (NYSE: TWX) HBO unit, which grew to 28.77 million subs in the U.S., which is a modest addition of only 50,000 subs in 1Q13. Netflix's relatively simple business model along with a lower price point has aided the company in its surge ahead of HBO. However, HBO is a mammoth in the production of high quality content and earns a lot of profits due to a much higher retail price of roughly $15. 

International Subs Has a Big Addressable Market; DVD is not unwinding

However, the real growth story of Netflix is firmly rooted in its international operations. The company is losing money from its international business, a phenomenon likely to continue for another 2 years, according to the company's management. Netflix’s international subscriber base increased a healthy 1.03 million to end 1Q13 at 7.14 million subs.

Revenues from Netflix’s International Operations contributed 14% of global revenues for Netflix. The company saw reduced losses or improved profit levels across all of its International Segments. And the company is not expecting an improvement in profitability for its International operations because it will ramp up its content library in line with revenue growth. 

Netflix added more payment options in the LatAm region, which was a decent headwind for the company’s growth in that geography. Netflix launched in an additional European market in 2Q13 which was the Netherlands. Netflix will be adding more International markets which will be dependent upon the company’s global profitability and the growth prospects of the respective geographies. Once Netflix achieves the scale in a certain geography, it will be able to deliver a long-term stream of profits due to its business model. 

The company's DVD business is declining at a much slower pace than previously expected, and ended Q1 at 7.98 million subscribers. Netflix’s DVD segment had a $113 million contribution profit which represented a contribution margin of 46.6%, the sequential decline in DVD contribution margin is due to higher usage historically in Q1. And the margins are likely to remain in this level, as a lot of subscribers still like to watch movies from physical discs. 

Signing mix of original and exclusive content deals

Netflix recently signed long-term content deals with Time Warner subsidiaries, Turner Broadcasting and Warner Bros. for adding a number of popular shows produced by various arms of Time Warner. Netflix is increasingly leaning towards being a curator of popular TV Shows and movies, instead of bulk content deals from studios and producers.

In addition, Netflix got into newer content deals with Fox Television Studios and AMC. However, Netflix didn’t renew its broad content deal with Viacom, but is looking to add select shows from Viacom Networks. In addition, Netflix heavily expanded its content offerings for children by signing deals with Disney, Cartoon Network, Hasbro and DreamWorks Animation (NASDAQ: DWA).

In 2Q13, Netflix struck the biggest deal for original content in its operating history with leading anime producer, DreamWorks Animation. Under the terms of the agreement, DreamWorks will produce more than 300 hours of new original programming for Netflix based on popular anime characters and franchises of DreamWorks, and also from the library of Classic Media, which DreamWorks acquired in 2012. And the first slate of original shows under the deal, will kick-off in 2014 and will be available in all Netflix territories.

In addition, Netflix is bringing back second seasons of a number of its original shows including Hemlock Grove, LilyHammer, Orange is the New Black as well as House of Cards, which goes on to prove the company’s ambitions of turning into a full- fledged Internet TV Network. 

Customers are tuning in; Dominates Internet video with 90% units. 

In 2012, Netflix stated that the company’s total monthly viewing hit 1 Billion hours. And just in April 2013, Netflix CEO released data stating that in 1Q2013, the company’s cumulative viewing notched up to 1.33 Billion hours on a monthly basis, or 4 Billion hours for the first 3 months.

Accelerated subscriber viewing hours in 1Q13 further reinforces the conviction that the Netflix story keeps getting better. And with more unique sub additions in the near-term and long-term, total subscriber viewing hours will climb higher. According to the NPD Group, TV viewing through subscription video on demand (SVOD) increased 34% on a year-over-year basis in 1Q13.

And NPD's Digital tracking showed that Netflix absolutely dominates the sectors with a whopping 90% share of TV video-streaming units in 1Q13. Netflix is substantially ahead of Hulu and Amazon for TV viewing--Hulu Plus has 10% share of TV Streaming and Amazon Prime accounted for only 2%.

Going forward

The domestic streaming subs of Netflix are expected to hit close to 30 million and the International unit should have subs of more than 7.5 million in Q2.  Netflix will get substantial tailwind from the increased penetration and the usage of more-internet connected devices. As content consumption is largely platform agnostic, the customers should be increasingly choosing Netflix due to the tremendous value it provides to users. Netflix’s International business is still in investment mode at large, and can be a major driver of the company's long-term profits as well. Netflix's virtual monopoly in the over-the-top streaming business will lead to strong earnings in the future.

 

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

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