Netflix's (NFLX) stock has jumped more than 35% following its Q4 2012 earnings announcement. The company ended up beating its own guidance and surprised investors by reporting a profit in the fourth quarter. This resulted from higher-than-expected streaming subscriber additions and better controlled costs, which provided operating leverage. Netflix also saw lower DVD subscriber losses.
Can we safely assume that Netflix is out of troubled waters? Perhaps not.
Although things are looking better than before, the uncertainty around content costs and growing competition still exists. The contest for getting a share of viewers' viewing time is not just limited to other pure-play streaming companies, but also encompasses individual networks, media companies and pay-TV service providers that are promoting their own streaming services. Netflix is trying to differentiate itself with content, but over time that differentiation could be difficult to maintain. In addition to this, the high margin DVD business is declining. We cannot simply ignore the risks in Netflix's business where profits are hard to come by and customer loyalty isn't that great.
Subscriber Gains Provided Leverage
Netflix added over 2 million domestic streaming subscribers, taking its full year net subscriber additions to around 5.5 million as compared to its previous expectations of 5 million. Additionally, DVD subscriber losses declined for the fourth consecutive quarter, amounting to 380,000.
As far as the international business is concerned, Netflix had the best quarter so far, adding close to 1.8 million net subscribers. Given that the company's costs are fixed in nature, the subscriber growth directly adds to its margins. This is the reason why the domestic profits were higher than what the company expected and international losses were lower. As a result, Netflix reported a small profit after guiding for losses during its Q3 2012 earnings announcement.
Why was the company able to do well in terms of subscriber gains?
It appears that Netflix saw a significant improvement in subscriber churn driven by better content, an improved image and a simplification in payment systems. In addition to this, the company also benefited from its launch in Nordic countries.
Growth from international markets has started to pick up with international subscriber gains coming fairly close to domestic gains in the fourth quarter. Netflix seems to have chosen the right markets in which to expand and may expand into another market in the latter half of 2013 or 2014. The company has made it easy for its subscribers to leave and join the service, thus eliminating hassles for returning customers.
However, Do Not Ignore the Competition
Investors must not forget that the international business is still incurring losses and much of Netflix's value is hinged on its performance in the U.S. Its high margin DVD business in the U.S. is still declining. Although the rate of decline has slowed down, we do not foresee a case where the DVD subscriber base will stabilize, let alone grow. As far as the U.S. streaming subscription business is concerned, the overall market growth is bound to slow and rising competition will make life increasingly difficult for Netflix. Competition will not only make it tough for Netflix to gain or retain subscribers, but it will also impact its margins as competitors bid up the cost of content.
According to Bloomberg, Amazon Prime had between 3 to 5 million subscribers around Oct 2011 and was planning to increase this count to 7 to 10 million subscriber by the end of 2012 or middle of of 2013. As far as content is concerned, Amazon (AMZN) had over 22,000 titles in its streaming library in August 2012, representing 70% growth in 2012 alone. The company further signed a deal with Epix in September to add 3,000 more titles to its library, bringing its total to 25,000.
It appears that Amazon Prime's subscriber base is sufficiently large to cause concern for Netflix. In addition to this, its streaming library seems to be growing quickly and seems sufficient enough to attract customers. Netflix cannot ignore Amazon's growing subscriber base and streaming catalog, and we believe this presents the highest competitive threat in the U.S. streaming market.
Apart from Amazon, other potentially dangerous players are Comcast (CMCSA), Verizon (VZ) and Dish Network (DISH). They may be lagging right now, but they can pose a significant threat over the next few years. Comcast launched its Xfinity Streampix offering in February 2012, allowing its subscribers to complement their existing pay-TV packages with additional streaming service. The service is available at $4.99 per month, $3 less than what Netflix charges, and is therefore very competitively priced. Comcast stated during its Q2 2012 earnings announcement that it had doubled the titles available for streaming Streampix since its launch. The company is clearly motivated to improve its streaming content since it is charging separately for it and wants to use it as one of the methods to stem its pay-TV subscriber losses.
Dish Network offers its sling DVR technology to its subscribers, allowing them to remotely access pay-TV programming. Adding Blockbuster streaming is an excellent move as it gives subscribers the flexibility to watch what they want, when they want and from wherever they want. The Blockbuster streaming service was launched in late 2011 and has helped Dish improve its subscriber trends. With the FCC granting Dish a waiver to build a wireless network, Dish will get more aggressive in promoting its streaming service by selling streaming devices that will work on its broadband network.
It is also interesting to note that the streaming services from Amazon, Comcast and Verizon-Redbox are priced cheaper than Netflix's service, which may be a concern as their content libraries develop. Lastly, let's not forget the efforts from media companies themselves such as the joint venture Hulu as well as premium networks such as HBO. We believe that Netflix is going to find itself surrounded with streaming behemoths in the near future, and this could pose a significant threat to its growth outlook.
Our price estimate for Netflix stands at $97, implying a discount of about 30% to the market price.
Disclosure: No positions.