Netflix May Lag Behind This Year

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 |  About: Netflix, Inc. (NFLX)
by: Alpha Strategist

The US entertainment media industry is at a major shifting point. Cable connections might shrink while more and more viewers move to on-demand, high quality entertainment media. The focal point of this article is Netflix Inc.'s (NASDAQ:NFLX) expected future performance as a result of various changes taking place within the company and industry.

Netflix is a California-based company that provides on-demand internet streaming media. Netflix distributes its services within the US and internationally mainly through digital subscriptions. Functionally, the revenue base of the company is distributed among three major segments, wherein the domestic streaming segment contributes about 63% to the total revenues of the company. The revenue contribution by each of the segments is indicated in the pie chart below.

Source: Earnings Report Q4

The company's revenues plunged towards the start of 2012 as a result of increasing subscription fees in 2011 coupled with a possible proposal regarding the DVD segment's spin off. This led to dismal per share earnings throughout those years. The company invested heavily in its R&D and marketing departments following the slumping growth in the top line of the company. The quarters after that showed positive yet fluctuating growth rates. However, the fluctuation is nothing more than seasonality following which the revenues trend upward during the holiday seasons and follow a downward trend during the second and third quarters. The pattern is quite visible from the revenue growth (%) shown in the graph below.

Source: Quarterly Statements

During the first quarter of 2014, the regions in which the company operates have seen extreme weather conditions. Bad weather has always had a positive impact on the top line of the company since it provides readily available indoor entertainment to children, adults, and families alike. However, one point of concern for the company is that Netflix's media streaming speed is slowing down and video quality is getting blurry. Previously, Netflix rapidly made its mark with US viewers and is now responsible for devouring a large portion of bandwidth which makes it hard for network providers to cope. Therefore, network providers are forcing the company to pay extra fees if they want the networks to maintain their streaming speed and quality. Reportedly, Netflix's buffering speed dropped by 14% in January on Verizon Communications' (VZ) FiOS. Since Verizon is a leading network service provider in the US, a drop in Verizon's speed will create a devastating impact on Netflix's top line if the company does not fix the problem soon. Viewers quickly switch to other brands providing reasonably good service if anything impairs their entertainment thus leading to declining subscriber base.

More likely than not network providers will win this battle even though the FCC is struggling to make a decision in Netflix's favor. Another problem with paying network providers fees is that they will be transferred on to consumers who will end up paying higher fees for the same service. The overall impact of these debates and a possible outcome of increased subscription fees will likely put a downward pressure on the price of the stock. The domestic subscriber base of the company has increased at a CAGR of 5.3% over the past 8 quarters. However, a dent is likely to occur, at least in the short term, on the continuously growing subscriptions for the reasons stated above. However, when you look at the recent history the company did recover from a similar situation in 2011 when the revenue growth plunged as a result of increased subscription fees. That was before the competition gained strength. In 2014, new competition began stepping in and this will likely hit the subscriber base of the company hard.

Amazon Prime Instant, Hulu Plus and HBO GO are expected to eat up as much as 3% of Netflix's subscriptions in 2014. All three of these competitors are much stronger compared to Netflix with huge existing subscriber bases and long contracts with leading broadcasters.

Looking at the international operations of the company, the Netflix-Sohu agreement in terms of "House of Cards" might open up new opportunities for the company in China. The show has already bagged about 24.5 million viewers since March 2013. However, it is not all good news. We are talking about giving the licensing rights to just one show here and that will not have a very big impact on the margins of the company. We could still interpret this as an effort to increase brand awareness to reap long term benefits had Netflix's own name become popular but the show is largely referred to as a Western show instead of a Netflix property. However, the news is still relevant enough that a large Chinese consumer base is interested in this "Western" show.

In light of the discussion above, I believe that 2014 is going to be a rather tough year for Netflix. It is hard to predict the long term future of the company in the wake of increasing competition from strong competitors and the ongoing war with network providers. The growth of the company will certainly slow down since HBO, Amazon (NASDAQ:AMZN), and Hulu will likely take up a large chunk of potential subscribers. The subscription fee gap might narrow between Netflix and other providers as well. That being said, other competitors are struggling to capture a meaningful subscriber base in China and given that the Netflix brand is not very popular in the region. It might be tough for the company to keep up with other competitors in the region.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.