Netflix' (NFLX) stock jumped almost 25% in after hours trading as the company reported strong subscriber additions in tandem with margin growth. As we anticipated, domestic streaming gains were strong while international losses were lower. In Q4 2012, 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. The momentum continued in Q1 2013, as Netflix added another 2 million domestic streaming subscribers.  In addition to this, DVD subscriber losses declined for the fifth consecutive quarter, amounting to 240,000. 
While everything seems to be going well for Netflix at the moment, its valuation appears to be too steep to us given the growing competition in the U.S., declining DVD business and expected increase in costs. While there is ample opportunity to expand internationally, high losses imply that the value of Netflix’s international streaming business is still low.
Exclusive Content And Marketing Are Driving Streaming Subscriber Growth In The U.S.
Netflix stated that its content advantage was the biggest driver of its U.S. streaming subscriber growth.  The company has been adding some original and exclusive programming to its streaming library, which seems to be paying off. TV series such as House of Cards, Lilyhammer and Arrested Development are drawing a lot of audience and attracting customers to sign up. In fact, Netflix has effectively marketed these exclusive shows to maintain its subscriber momentum.  While premium networks such as HBO have peaked at around 30+ million subscribers, Netflix sees a much larger opportunity and addressable market size of 60 to 90 million subscribers in the U.S. 
Netflix is also benefiting from the proliferation of smartphones, tablets and other connected devices as well as a general consumer shift to the Internet. Its streaming service constitutes almost 30% of peak Internet traffic in the U.S. Although the competition is increasing, the company has the first mover advantage since it pioneered the subscription streaming service. Besides some of the exclusive shows that we mentioned before, Netflix also signed a deal with Disney (DIS) last year to gain exclusive access to some of its 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 through deals with Turner Broadcasting, Warner Brothers Television Group, DreamWorks Animation and Hasbro Studios. 
We have slightly raised our forecast for Netflix’ U.S. streaming subscribers and expect the figure to reach close to 45-50 million subscribers by the end of our forecast period. For more details on how big can Netflix become in the U.S., see our analysis How Big Can Netflix’s U.S. Streaming Business Get?
International Growth Is Strong
Netflix delivered strongly on the international front as it added a little over 1 million subscriber in the quarter.  The net subscriber additions were closer to the high end of its guidance. In addition to this, it reduced its international losses, which is an encouraging sign.
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% in Latin American households over the next 6 to 7 years, it can gain close to 7-8 million subscribers in this region alone.
The company stated that it will launch in another European market in the later half of 2013. The company's ambitions remain strong fueled by its rejuvenated growth in the U.S. that allows it to generate enough cash to invest in international expansion.
However, Consider These Risks!
DVD Rental Decline
From 19.5 million in 2010, Netflix’s DVD subscribers declined to 8.2 million by the end of 2012. The first quarter of 2013 saw a net DVD subscriber loss of about 240,000.  These declines are likely to continue as Netflix continues to improve its streaming content. The DVD rental business is still a high margin one for the company. Although it expects to maintain these margins in 2013, the decline is inevitable as the subscriber base shrinks. 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.
Investors must not forget that the international business is still incurring losses and much of the company's value is hinged on its performance in the U.S. As far as the U.S. streaming subscription business is concerned, the overall market growth is bound to slow and rising competition which will make life increasingly difficult for Netflix. Competition will not only make it tough for Netflix to gain or retain subscribers, but will also impact its margins as competitors push up the cost of content. Netflix acknowledged that high bidding from Amazon (AMZN) and Hulu is notably impacting content prices.  Although the company was able to grow its revenues faster than costs in Q1 2013, it may not continue to do so in the future.
While Amazon is still behind Netflix in terms of content, it is evident that the company is slowly trying to close that gap. It appears that Amazon Prime’s growing subscriber base could be a concern for Netflix in the future. We believe that as of now, Amazon presents the highest competitive threat for the company in the U.S. streaming market. Apart from Amazon, other potentially dangerous players are Comcast (CMCSA) (CMCSK), 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 subscribers to complement their existing pay-TV packages with the 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 the service’s launch. The company is clearly motivated to improve its streaming content as it is charging separately for it and wants to use it as one of the methods to stem pay-TV subscriber losses.
DISH Network offers the 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 Federal Communications Commission (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, 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.
Our price estimate for Netflix stands at $133, implying a discount of about 40% to the market price.
Disclosure: No positions.