Netflix Is Poised to Outperform

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

Netflix (NASDAQ: NFLX) has brought a number of game-changing innovations. The company's ability to innovate and build entirely new categories rapidly is unquestionable. Gone are the days of Netflix being a DVD-by-mail provider only, and the company is increasingly being more selective in choosing which TV shows it adds. The company's recent big bets on original content are paving the way for the creation of an Internet TV Network.

Netflix is the first Internet TV Network

Netflix has now started branding itself as the world's leading Internet TV network, and very justifiably. The company has recently taken a number of steps that completely justify that claim. The company's decision to take away a chunk of the production from DreamWorks Animation (NASDAQ: DWA) and also get into deals to create original shows based on the very popular franchise figures confirms that claim. 

Netflix is building up an audience for its shows by using its internal viewing data and consumer ratings to develop and build-out shows which will become popular among niche customers. The company's algorithms are at work and the data is being used to renew original shows and even negotiate licensed content from content producers like DisneyAMC Networks (NASDAQ: AMCX), and Time Warner (NYSE: TWX), and the company is not hesitant to walk away from deals which don't make financial sense from a viewership perspective. 

Franchise building is in session 

Franchise building by Netflix is laying the foundation for possible pricing power down the road, as Pay TV prices are expected to rise even more in the future. If Netflix manages to build a handful of successful franchises from its original shows, the company's fortunes will improve substantially. Netflix's management has always stated their admiration for Time Warner's HBO, and their desire to evolve into HBO rapidly. While, the likelihood of increasing prices in the next two years is almost non-existent, a price increase might come into effect in 2015, after Netflix has a strong slate of original shows in their second/third seasons.

The company is projecting that its original content expense will represent a small portion of its total content spend and viewing hours this year. Increased amount of original content will enhance member retention and driver user acquisition globally. Higher brand equity and value perception driven by Netflix-only shows can create a halo effect for Netflix and enable incremental word-of-mouth marketing among viewers. 

 In 1Q13, Netflix saw its marketing expenditure trickle down by more than 200bps on a year-over-year basis, which was largely driven by the free press surrounding the company’s original shows and an enhanced reputation. And also, Netflix is increasingly focused on marketing its brand across the globe for reaching out to newer customers in International segments. The savings from marketing can be used for adding more original content as well, which in turn, creates more media buzz.

Different strokes for different folks

Owing to the success of the original shows, the company is pondering a ramp in the number of shows to upwards of 20 annually, contingent upon viewership and performance of the original shows throughout the rest of the year. Netflix is tactfully adding more seasons of its current original franchises to build-up a solid fan base for its shows. The company decided to renew Orange is Black for Season 2 before it even debuted on the platform. 

Netflix is adding a lot of shows geared towards children and is also producing a show with DreamWorks called Turbo: Fast, which is a continuation of the launch by DreamWorks for Turbo anime on July 2013. The company's ambitions to turn into a full-fledged Internet TV Network can be gauged by the different types of shows for various types of viewers.

Netflix struck the biggest deal in its operating history to build a large number of original programming shows based on characters of DreamWorks. This is a great move for DreamWorks, enabling it to have more predictable revenue, unlike the theatrical movie business which has volatile and unpredictable revenues.  

If Netflix can build highly successful shows like Time Warner’s HBO, it can see sizable increases in its subscriber base. HBO's Game of Thrones had an average audience of 13.6 million per episode in this season, which is only behind the other hugely successful HBO show, The Sopranos, which had 14.4 viewers in 2004. On the other side, AMC Networks has a number of hit and critically acclaimed shows like Mad MenBreaking BadThe Waking Dead etc.

Netflix is licensing these shows from AMC, but if Netflix can develop shows like AMC and build its own franchises, the company's subscriber base should see sizable increases. Netflix's well-spaced original shows of one or two per quarter can drive subscriber numbers throughout the rest of 2013 not only in the U.S., but in International territories as well. 

<table> <thead></thead> <thead> <tr><th> <p><strong>Exhibit: NFLX Original Content Releases for 2013</strong></p> </th><th> <p><strong> </strong></p> </th><th> <p><strong> </strong></p> </th></tr> </thead> <tbody> <tr> <td> <p><strong>Title</strong></p> </td> <td> <p><strong>Air Date</strong></p> </td> <td> <p><strong>Season No. </strong></p> </td> <td> <p><strong>Genre</strong></p> </td> </tr> <tr> <td> <p>House of Cards </p> </td> <td> <p>Q1-2013</p> </td> <td> <p>1</p> </td> <td> <p>Drama </p> </td> </tr> <tr> <td> <p>Hemlock Grove</p> </td> <td> <p>Q2-2013</p> </td> <td> <p>1</p> </td> <td> <p>Horror/Thriller</p> </td> </tr> <tr> <td> <p>Arrested Development</p> </td> <td> <p>Q2-2013</p> </td> <td> <p>4</p> </td> <td> <p>Comedy</p> </td> </tr> <tr> <td> <p>Orange is the New Black</p> </td> <td> <p>Q3-2013</p> </td> <td> <p>1</p> </td> <td> <p>Drama/Comedy</p> </td> </tr> <tr> <td> <p>Derek</p> </td> <td> <p>Q3-2013</p> </td> <td> <p>1</p> </td> <td> <p>Drama/Comedy</p> </td> </tr> <tr> <td> <p>LilyHammer</p> </td> <td> <p>Q4-2013</p> </td> <td> <p>2</p> </td> <td> <p>Drama/Comedy</p> </td> </tr> <tr> <td> <p>Turbo: Fast</p> </td> <td> <p>Q4-2013</p> </td> <td> <p>1</p> </td> <td> <p>Animation</p> </td> </tr> </tbody> </table>

Source: Estimates, Company Data, IMDB

Content costs are manageable; Moody's happy with credit position

Netflix added just slightly less than $600 million in streaming content in 1Q, which is below the average for 2012 when the company added content at a pace of $628 million per quarter. Netflix will expand its original content slate as it gets more insight and confidence.

Netflix bears tend to point that the company's content costs are getting out of hand. However, that is not the case. Netflix had long-term and short-term commitments and liabilities of $5.7 billion (including off-balance sheet liabilities of $3.3 billion) at the end of 1Q13, which was a modest increase of only $100 million. The company has around $1 billion in cash, and $500 million in long-term debt, and its current ratio is above 1.5 as well. 

The company even converted $200 million worth of convertible debt into 2.3 million shares, which also enhanced its Debt/Equity Ratio. Credit rating agency Moody's says Netflix's conversion of its convertible notes is credit positive, and the company is on track to be well positioned at the Ba3 rating due to its improved profitability and growth in subscribers. The argument of Netflix bears is clearly flawed. 

The bottom line

At the end of 1Q13, the number of broadband subscribers in the U.S. stood at 82.4 million, according to Leichtman Research Group. As a result, Netflix's market penetration rate in the U.S. stands at roughly 35% of broadband households. Thus, the company's addressable market in the U.S. still has sizable room for growth from current levels of only 29.17 million subscribers. 

In 2011, it had a solid net income of $226.1 million and the company ended 2011 with 23.5 million subs. And fast forward to 2013, the company ended last quarter with more than 36.3 million subscribers. It is very evident that with a much larger sub base, and one that is actively growing globally, the company can deliver much higher bottom line numbers in the future. The company's addition of original shows will build up a loyal fan base among its subscribers, and limit its churn rate to record low levels as well.

The television landscape is changing quickly, with new entrants like Netflix and disrupting traditional networks. The Motley Fool's new free report "Who Will Own the Future of Television?" details the risks and opportunities in TV. Click here to read the full report!

Ishfaque Faruk has no position in any stocks mentioned. The Motley Fool recommends AMC Networks, 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!

blog comments powered by Disqus