If you have read my previous article on Netflix (NFLX), you'll know that I am not a fan of investing in the company. In my opinion the current valuation is based on the best-case scenario, and I think many bulls ignore the potential downside. Bulls often argue that Netflix has huge growth opportunities in the US by pointing to the fact that it "only" has captured 25M subscribers out of a potential 80M. The latter figure is based on the amount of US households which have broadband access. However, as I will argue in this article, that number does a poor job of quantifying Netflix's potential market size. Netflix is actually much closer to saturating the US market than bulls are aware of.
The market size myth
The problem with using 80M as the market size is that a subscription based streaming service is not relevant to many of the households. I relate to my grandparents as an example, and while they have broadband access, they are also completely satisfied with their cable-TV.
Instead, let me try to define a more useful measure for the market size:
The potential market size consists of households which are considering a purchase of a subscription based streaming service (either from Netflix or one of their competitors).
Quantifying the potential market size
Since a number for "the potential market size" isn't available to the public, I have to estimate it myself. To do that I read a few reports and surveys. One of the reports I found interesting was the 2012 US Digital Future in Focus report. The report estimates that 105.1 million Americans watch video online every day. I'll say it is fair to assume that if one watches online video on a daily basis, one also considers purchasing a subscription based streaming service. On a household basis this is equal to (105.1 * (115/311)) 38M households.
Some may argue that the above figure understates the potential market size, as it doesn't include users that watch online video 1-6 times/week (rather than daily). I think this is a fair point, and the potential market size is definitely higher.
To quantify the latter group, I used results from another survey (it's from 2010, but I will take into account in my final model) which estimates 70% of all Americans adults have used the internet to watch TV shows, movies or educational videos. That's roughly equal to 160M Americans. The amount of adults that watch online videos on a non-daily basis can now be quantified: 160-105 = 55 million.
Out of that group I estimate that roughly 50% are considering purchasing an online streaming subscription service. The potential market size can now be estimated as: 105 + 55 * 0.5 = 132.5M Americans. On a household basis this is equal to 49M households.
Estimating the growth rate
Other bulls may argue that my calculations so far have ignored the fact that the market is expected to grow at a high rate as a growing number of American adults watch videos online. This is a fair point, and to calculate the expected growth rate I used estimates from a research report made by Emarketer. The report estimates that the number of American adults that watch videos online will increase by 10 percentage point from 2010 to 2014.
To quantify the current and expected potential market size I have developed a model, which you can see in the below table.
In the graph below, you can see Netflix's historical and future estimated subscriber numbers. To estimate Netflix's future subscriber count I extrapolated the subscriber growth over the last 12 months into the future (as this is what I expect a lot of bullish analysts/investors do).
An extrapolation, however, implies an increase in market share from the current 49% to 60% in Q2 2014. This wouldn't be worrisome if the potential market size was 80M households, but since the potential market size by late 2014 is roughly 60M, Netflix's growth opportunities are less than what bulls expect.
The realistic market size
But it gets worse. Netflix's realistic market size is even smaller.
Many of the households have already clearly stated that they are not interested in paying for Netflix's subscription based service. Those are the households that recently have cancelled their subscription service. They have probably watched through most of the content Netflix offers or simply weren't satisfied with the content in the first place, thus they chose not to renew their subscription.
Therefore I have "invented" a second market size term; Netflix's realistic market size, which I define as:
The potential market size consists of households which are considering the idea of purchasing a subscription based streaming service from Netflix
By subtracting the subscribers who cancelled their subscription in the last 8 quarters, I have estimated the realistic market size in the below graph.
Notice how an extrapolation of subscriber growth implies that Netflix obtains a realistic market share of over 70% in 2014.
While Netflix's future subscriber numbers (if they come true) are impressive, that just raises the question; how is Netflix going to grow over a longer period?
The most profitable segment, the DVD-segment, is expected to decline, and while it likely will be (partially) offset by increased streaming subscribers, it's not going to give Netflix the double digit growth it needs to justify the current share price.
Other bulls may argue that Netflix will grow through the International segment, and I agree, it will. However, there are 4 problems with basing your bullish case on the International segment:
- Every time Netflix expands to a new geographical segment it has to go through a period in which it loses money.
- Netflix has shown through its expansion in Latin America that it didn't really understand the market. This signals that management is not always performing the necessary due diligence prior to the expansion.
- Netflix has no fundamental competitive advantage compared to the local competitors. Rather, its competitors understand the local market better as they have been in the country for a longer time.
- Netflix might not have foreseen the local competitor's reactions. In Netflix's recent expansion to Denmark, it began by offering a one-month subscription for $13. However, the main competitor, Viaplay quickly responded by reducing its price from $18 to $13 as well. As Viaplay currently has more content for the same price, there are no reasons why customers should subscribe to Netflix.
While I acknowledge that many of my estimations and assumptions in this article are very rough and may not be that accurate, I still think the realistic market size is a better indicator of the potential growth rate than the broadband measure.
Sure, the "true" market size could be 46M or 37M. But the point still remains; Netflix is getting pretty close to its potential in the US and looking forward, growth opportunities are limited.