Netflix Is Becoming an Entertainment Powerhouse

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

The evolution of Netflix (NASDAQ: NFLX) is underway as the firm laid out its intention to grow the breadth of its original programming into newer genres like documentaries and stand-up comedy. The company is following in the footsteps of Time Warner's (NYSE: TWX) HBO by developing an original content library of HBO's quality in the future. However, Netflix doesn't require basic tier cable and is accessible from most wireless mobile devices, which gives it an edge to increase its subscriber base to much higher levels relative to HBO. 

Growth in place

Netflix has seen solid momentum in adding subscribers, as the total number of subscribers increased to more than 37.5 million subs globally. The company’s revenues in 1Q13 stood at $1.07 billion, which represents a 17% Y/Y growth, and it had an operating income of $57 million. The company’s margin profile is improving, as the company’s net income was above expectations in the last quarter.

In addition, Netflix churned out surprise free cash flow of $13 million in 2Q13, which is the first time in the last four quarters. The company has been spending heavily in adding new content across various geographies, and signing relatively more expensive exclusive and original shows as well. 

Domestic streaming is enjoying scale

Netflix’s domestic video streaming business has been enhancing its contribution margin. As content expenditures are amortized over a larger revenue base due to a larger subscriber base, the company’s contribution margin in the U.S. is likely to see sequential increases almost every quarter in the near future. Netflix’s management is expecting the company’s contribution margin in the domestic market to increase by roughly 400 bps per year.

At the end of 2Q13, Netflix had more than 29.8 million U.S. subscribers, and going forward, the company will find it harder to grow as the company’s penetration in the U.S. increases. Competing services from Amazon and Disney (NYSE: DIS) backed Hulu are also placing larger bets in the future of Internet TV by spending more on building a large and lucrative content library for over-the-top subscribers.

The release of Arrested Development led to a small bump in subscriber additions in Q2, roughly 630,000 in the U.S. market. Netflix didn’t renew its content deal with Viacom which led a lot of shows from Nickelodeon to disappear from the service. However, Netflix has a multi-year contract with Disney to add shows for children, including a number of high-quality shows from Disney Jr. 

Rising competition 

All the leading players in the online streaming business are producing original shows to make their services distinct from one another. The trio of owners at Hulu, which includes Disney, Fox, and NBC, laid out a cash injection of $750 million to enable Hulu to compete more broadly in the Internet TV space with Netflix and Amazon. At the end of 2Q13, Netflix had 36 titles overlapping with Hulu, and 68 with Amazon Prime for the top 200 titles on Netflix.

Hulu has the potential to be a much larger player in the space, as it gets next-day content from Disney's ABC Network, and also from the other owners. In addition, Disney owns some of the most lucrative portfolios of entertainment properties in the world, including Marvel, Lucasfilm, Pixar, and its own Studio and Network content, all of which can be effectively marketed through Hulu in the future. As a result, the decision by Disney and its partners to retain the ownership of Hulu, will lead to far more competition in the Internet TV space in the long-term.

Long-term outlook for International; DVD should be around

In the last quarter, subscribers saw steady growth in all 40 countries in which Netflix operates and also recently rolled out its operations in the Netherlands. Going forward, if Netflix can add 1 million subscribers per country in the next few years, which is a reasonably conservative assumption, the company’s international sub base will jump to 40 million subscribers from the 7.75 million at the end of 2Q13.

As a result, sizable increases in both the top and bottom line from the international segment are almost certain for Netflix. The company is planning to ramp up its content library for International subscribers to provide a better user experience, which will impact its contribution losses from the overseas segment. Netflix is plowing back almost all of its domestic profits for its International expansion. As a result, Netflix is likely to remain in this investment mode for a couple of years before its sees sizable increases in the bottom line.

Netflix still offers a huge selection of DVDs to consumers from rival networks like HBO. Since DVDs are released roughly 30 days after broadcast, consumers can get their hands on recent releases via Netflix. The company’s domestic DVD segment still has more than 7.5 million subscribers, and boasts a contribution margin of 47% for Netflix. Going forward, Netflix is widely expected to lose DVD subs, as more consumers opt-in for digital media consumption.

An entertainment powerhouse in the making

Netflix continues to reposition its image in the eyes of its global subscriber base by adding high-quality original shows on its platform. The company is commissioning the second seasons of all the original shows thus far. And the company is in discussions to add Season 5 of popular comedy show, Arrested Development.

And the company is well on its way to becoming an entertainment powerhouse with 14 Emmy nominations for Netflix’s originals. The company’s management intends to add more Netflix originals for newer genres, and even movies. However, Netflix still lags Time Warner's HBO by a huge margin. HBO was the recipient of 108 Emmy nominations, which was substantially higher than rivals. Game of Thrones has become the second most watched show in HBO’s history with an average audience of more than 14.2 million per episode.

High-quality shows like Game of Thrones will only see increases in viewership for HBO. If Netflix can produce a few top franchises by adopting Time Warner's playbook in the next few years, the company can possibly implement a price increase to bring it more in line with other pay TV channels. Reed Hastings stated that he wants to increase the company’s original programming in the next year, which should garner more publicity for the company. 

And as video streaming devices become more popular among consumers, Netflix will be a beneficiary from this trend. The $35 Chromecast from Google, as well as existing devices, including Apple TV and Roku will resonate with more consumers in the future, and potentially aid subscriber growth. Roku streamed more than 1 billion hours of content in 2012, and going forward this is likely to increase substantially. The company's commitment to build a large catalog of proprietary and high-quality content, coupled with secular drivers, will transform Netflix into a major entertainment powerhouse from its earlier days of being just a content distributor.

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Ishfaque Faruk 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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