Chill Over Netflix, Things Aren't That Bad

| About: Netflix, Inc. (NFLX)


US prices and profitability continue to rise steadily.

International losses quite reasonable considering expansion.

Balance sheet is not in bad shape currently.

Netflix (NASDAQ:NFLX) continues to be one of the most polarizing stocks in the market. With the company's Q4 investor letter, the bulls celebrated international growth, while the bears discussed the usual concerns. With shares well off their yearly high thanks to recent market weakness, the most recent report gives investors multiple reasons to stay positive.

US progress continues to impress

When it comes to US streaming, the Q4 report didn't really change anything. Total sub growth is slowing, while the segment is becoming more profitable. Netflix already has a large subscriber base, so it's reasonable to expect smaller sub gains. One of my 2015 predictions was that we'd see less than five million domestic streaming sub adds, and I feel confident in that. However, the more important story can be seen in the two charts below showing quarterly revenues and contribution margin divided by the end of period paid subscribers figure.

Click to enlarge

Since Q1 of 2013, the revenue per sub quarterly figure has risen by $2.60. This is mainly due to newer subs coming in at higher rates, plus the success of higher price plans like the $11.99 Ultra-HD plan discussed in the investor letter. This figure will continue to rise this year as price grandfathering on the HD plan ends. While this will cause slightly higher churn, Netflix will benefit from moving subs up the price ladder.

More importantly, the company has dramatically improved the profitability of this segment in recent years. Contribution margin per sub has risen by over $4 since Q1 2013. For those that question rising content costs, Netflix continues to improve the bottom line in the US streaming segment, and management reiterated its 40% target for contribution margins in this segment by 2020. In Q4 2015, Netflix was at 34.3%, up 530 basis points in the past year.

International losses seem very reasonable

One part of the bear case is that Netflix continues to rack up sizable losses internationally. While that is true, it is due to the aggressive expansion plan currently underway. If you want subs to grow, you have to add new markets. Below, I've pasted the international streaming table from the Q4 investor letter.

Netflix launched in 130 countries on January 6th, making the service available to tens of millions more potential subscribers. Given such large expansion, I'm actually surprised that the company only guided to a $5 million sequential decline in contribution profits (an increase in losses). The contribution margin percentage actually is forecast to rise sequentially, showing the strength of current markets.

Bears talk about increased losses, but this is how the business works. Think about these new markets that were recently entered in early January. Netflix will realize almost a full quarter of expenses in these areas while operating, but the company's free month trial means less than 2 months of revenues are technically recognized. This process will smooth out throughout 2016.

Look at where Netflix is as a whole. The company guided to a $0.03 profit in Q1, despite increasing its international losses to expand into many new markets. Once those losses mitigate, profitability will start to take off. Here's where analysts' estimates currently stand for the next couple of years:

(Source: NASDAQ Netflix analyst estimates page)

Balance sheet not in bad shape

I understand that Q4's cash burn of $276 million was not pretty. This figure has accelerated in recent quarters, because original content requires more upfront payments. It is these original shows that have helped Netflix grow in recent years, and they will be a major part of the company's future success.

The company ended Q4 with about $2.31 billion in cash and equivalents, versus $2.37 billion in debt. Management says it will raise funds later this year or early next year. Another debt issuance could come even earlier than that if interest rates decline and management thinks it can get a good deal.

What's the big deal though if Netflix needs to add another billion of debt? We're talking about a company that has a market cap of around $44 billion, and that's with shares more than 20% off their highs. At $3.5 billion in debt, Netflix's balance sheet would still be in fairly decent shape. Also, even at a 6% interest rate, we're only talking about $40 million in extra interest expenses per year. That's nothing for a company currently increasing revenues by about $2 billion per year, expected to total about $11 billion in 2017.

Final thoughts

Another Netflix quarter is in the books, and the bear camp is back again with its criticisms. While I used to be part of this group, I realized that the company isn't in as bad of shape as some make it seem. The company still hasn't gone bankrupt, the DVD business is still doing well, and US subscribers are still growing at a decent rate. Netflix will be a big part of future television and movies, so even at a $44 billion market cap, there is still room for this stock to grow.

(Author's note: All charts/tables in this article were taken or derived from Netflix's financials and quarterly earnings letters - found here)

Disclosure: I/we 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.

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