Netflix: Bullish On The Product, But Valuation Seems Expensive

| About: Netflix, Inc. (NFLX)


Netflix is expected to grow its subscribers significantly both in the U.S. and internationally.

International markets present a significant growth opportunity, which I think the market is under appreciating.

Netflix has developed an impressive consumer product over the years and is setting the standards for media delivery.

Although Netflix (NASDAQ:NFLX) faced many ups and downs in the past few years, the company has made an impressive transformation to a streaming TV/movie business. NFLX is currently the largest pay TV channel in the U.S. Moreover, the company's efforts for continued growth and expansion both in U.S. and internationally are expected to yield positive results.

The company's valuations remain a debate but I will come to that later. However, Netflix the product is here to stay for long run. The company has strong upside potential as subscriber growth continues, driven by increasing use of connected devices, stronger international footprint, and margin expansion through scaling content sourcing.

Significant Growth in Subscribers

With more than 35 million subscribers in the U.S., the company is the largest pay TV channel in the U.S. Moreover, in the next ten years, the company expects to increase its subscribers to 60-90 million in the U.S. alone. This healthy growth should in turn drive the company's margin expansion.

According to the U.S. Census Bureau, there are about 115 million households in the U.S. Even if the company provides services to half of these households, it would be a significant boost to revenues. Moreover, at a cost of $7.99 (old members) to $8.99 (new members), compared to the one that costs more than 10 times as much, how many users are expected to cancel their subscription? Morgan Stanley (NYSE:MS), which has a price target of $500 for Netflix, believes that NFLX has the ability to increase its U.S. members to ~55 million as the churn declines over time and NFLX increases its penetration of broadband houses.

International Market - A Big Growth Opportunity

The international market presents the biggest growth opportunity to Netflix and will be the single biggest factor, which will influence its long-term value. The international growth opportunity is one of the factors that have propelled the stock to its new high. Netflix expects its international operations to be become profitable this year and will eventually outperform its U.S. operations. The company can get a significant profit boost through growth and operating leverage in its international unit, once it begins to raise its prices.

The company has grown its subscriber base by roughly 12 million users (a CAGR of 141%) during the last three years. The company also reached a revenue run rate of roughly $900 million while recording $800 million in losses associated with international operations. Although the average revenue per subscriber ("ARPU") overseas has been comparable to the U.S., the number of subscribers and profitability significantly lags behind.

Netflix operates in 41 countries (including North, Central, Latin America, and Caribbean) internationally; however, they contribute only a quarter towards the company's revenues. The company plans to enter into 6 new markets in Europe this year, including France, Germany, Austria, Switzerland, Belgium and Luxembourg, and then 2-4 new markets in 2015 and beyond. The company is expected to expand into France and Germany in the second half of 2014.

NFLX's costs are expected to continue to rise because of its entry into new markets and continued expansion of the content in existing international markets. While the company believes its international operations would turn profitable this year, I do not expect a significant increase in profits this year. However, in the long term these operations will eventually turn profitable and will prove to be a big growth engine for Netflix.

The Whole Package Offers Enough to Keep Subscribers Interested

The pay-TV channel success basically depends on the content that it provides to its users. At the beginning, the company only had a library of DVD movies to offer to the subscribers but since then it has moved towards TV content and streaming TV content. Now combine this with originals, Netflix has evolved into a product that might not be offering you everything but the whole package offers enough to keep consumers interested.

Netflix plans to spend a staggering $3 billion on TV and film content during 2014 and more than $6 billion over the next three years. Now the content acquisition could mean different things in different markets. For example in the U.S., where the company already has a strong position, content acquisitions are not that important as in international markets. Now I'm not saying content is not important for the U.S. consumers, it is. But major content acquisitions will not be a driving force of subscribers' growth. The company needs to make acquisitions and introduce originals at the pace it is already doing to keep the subscribers growth at the current rate.

The international market, on the other hand, is entirely different. The company only has 12 million subscribers internationally and is expanding into many new markets especially in Europe. International market will be the biggest growth engine for NFLX and in order to succeed in internationally, Netflix will need to make major acquisitions and not just Hollywood content but the company will also have to acquire local content.

Netflix vs. HBO

While Netflix in the U.S. is already bigger than its direct competitor, HBO, the company will need growth of this magnitude in order to reach unchartered territory in the U.S. pay TV market. Despite of huge differences in their business models both Netflix and HBO are direct rivals to each other. As I mentioned earlier Netflix has 35 million subscribers in the U.S., HBO in comparison has approx. 29 million subscribers. However, when combined with Cinemax, that number jumps to 43 million.

While Netflix has more subscribers in the U.S., on the international front HBO has significantly more subscribers than Netflix (85 million compared to 12 million). Netflix reported $4.4 billion in revenues and $350 million in EBITDA for 2013 as compared to the HBO's revenues of $4.9 billion and EBITDA of $1.8 billion. The company reported lower margins in both the U.S. and internationally than HBO despite the fact that HBO currently spends approx. $1.5 billion a year on original content compared to the NFLX's $300 million spend. Netflix subscriber growth rate is nearly 25% compared to a modest growth shown by HBO both in the U.S. and internationally.

I believe Netflix's super subscribers' growth forecast is realistic, as the tech-savvy, content on demand generation grows larger, Netflix would be one of the biggest beneficiaries of this trend. Although the company has the capability of growing its subscriber base, the size and speed of the growth as well as the cost to achieve it will govern the company's stock price.


NFLX stock started on a high note in 2014 and the share price touched an all-time high of $458 on the back of the strong 4Q14 results. As you can see from the chart below, NFLX is up by a whopping 124% over the last year. The recent reports of Morgan Stanley and Goldman Sachs (NYSE:GS) have also pushed the stock higher. Goldman Sachs, which recently added the company to its buy list, has a 12-month target price of $590. Morgan Stanley, which also rates the company buy, has a relatively modest price target of $500.

Both these firms have highlighted subscribers' growth, stronger international footprint, and expanding margins as the reasons for their buy ratings. I'm long on NFLX for the very same reasons and others that I have mentioned in the report. However, at the current P/E of 179 and forward P/E of 78, NFLX seems expensive to me and I will wait for a better entry point.

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(Source: Google Finance)


Netflix has developed an impressive consumer product over the years and is setting the standards for media delivery. The company has the ability to leverage the growth in connected device ecosystem and continue its expansion internationally. As the Goldman Analyst noted in his report, the subscriber growth both in the U.S. and internationally will continue to exceed the expectations, driving margin expansion through significant scale benefits in content sourcing, customer acquisition, and technology. The company's expectations for continued growth both in U.S. and internationally is also not unreasonable. I'm long on Netflix; I see huge potential in the company. However, after the recent rally in stock I will wait for a better entry point.

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