Netflix (NFLX) will report its Q1 2013 earnings on April 22. We anticipate solid quarterly results as we expect Netflix to grow its overall subscriber base while reducing international losses. Last quarter Netflix added over 2 million domestic streaming subscribers taking its full year net subscriber additions to around 5.5 million compared to its previous expectation of 5 million. In addition to this, DVD subscriber losses declined for the fourth consecutive quarter amounting to 380,000. It appears that the subscriber growth has improved significantly over the past few quarters and the momentum continued in Q1 as well. Also, the company didn’t expand to any additional international markets. Therefore, we expect international losses to come down as Netflix solidifies its position in its existing markets.
Streaming Business Outlook Still Looks Healthy
Given the recent improvement in Netflix’s streaming subscriber trends, we expect the momentum to have continued into Q1 2013. Netflix’s content advantage in the U.S. and expansion in international markets will continue to drive subscriber growth.
Situation In The U.S.
Netflix is still doing well in the U.S. due to its content advantage, growing broadband penetration and increased usage of smartphones, tablets and other connected devices. Having multiple devices that are connected to the Internet, easy to use, mobile and sleek, perks up the appetite and desire for streaming video content.
Netflix is benefiting from this trend and now constitutes almost 30% of peak Internet traffic in the U.S. Although the competition is increasing, the company has the first mover advantage as it pioneered the subscription streaming service. Netflix has been investing in original content such as House of Cards and Lilyhammer and it also struck a deal last year with Disney (DIS) under which it will get exclusive access to some of the latter’s content once the contract between Starz and Disney expires in 2015 (see What Are The Implications Of Netflix’s Deal With Disney?). During the first quarter of 2013, Netflix continued to expand its streaming content with deals with Turner Broadcasting, Warner Brothers Television Group, DreamWorks Animation and Hasbro Studios. 
For more details on how big can Netflix be in the U.S., see our analysis How Big Can Netflix’s U.S. Streaming Business Get?
Netflix expects to add between 500,000 and 1.2 million net subscribers in international markets in Q1 2013. We believe that this may be possible given the traction that the company is getting in these markets. Currently, Netflix is present in Europe, Latin America and Canada.
With Canada and Europe being developed markets, Netflix is positioned well to capture market share in these regions. The broadband penetration is high and average broadband speeds are good enough to foster growth in streaming services. Overall we believe that Netflix can target a total of 38 million households in its current markets in Europe and can gain more than 12 million subscribers over the long term if it can emulate its success in the U.S. in these markets and can achieve a penetration close to 30% of households. In addition to this, Latin America presents good potential despite a slow start. The growing middle class, an expected improvement in payment systems and the lack of pay-TV penetration can help Netflix. We believe that if the company can achieve a penetration of even 5% of Latin American households over the next 6-7 years, it can gain close to 7-8 million subscribers in this region alone.
For more details on how big can Netflix get internationally, see our analysis Sizing Up Netflix’s International Subscriber Growth Potential.
DVD Business Will Continue To Decline
After Netflix raised its pricing and started offering a stand-alone streaming service in the U.S. in 2011, its DVD subscriber base fell significantly. In 2010, it had 19.5 million DVD subscribers and this figure declined to 8.2 million by the end of 2012. Most of these DVD subscribers shifted to streaming-only service when Netflix raised the prices for its hybrid service (DVD + streaming) around mid-2011. We expect that Netflix’s DVD subscribers will continue to decline every quarter. The availability of a wide variety of devices for streaming and improving broadband speeds have encouraged the consumer shift to Internet for video entertainment. Also, Netflix is spending heavily on improving its streaming content and over time customers will have less incentive to subscribe to its DVD rental service.
In addition to subscriber losses, the contribution margins for Netflix’s DVD business will continue to shrink. The primary costs governing these margins include revenue sharing and content acquisition costs, postage costs and DVD shipment center costs. While revenue sharing costs and postage costs are variable, other costs have large fixed components. With a smaller number of DVDs to handle, the company may lose out on the advantage of economies of scale and its distribution centers may not run as efficiently as they used to. In addition to this, the company may not get favorable pricing from studios due to a shrinking base and less negotiating power. The fixed costs of content acquisition will be spread out over a smaller revenue base, implying that Netflix will lose operating leverage. Moreover, rising postage costs will also put some pressure on its margins.
Our price estimate for Netflix stands at $125, implying a discount of about 30% to the market price.
Disclosure: No positions.