Netflix's (NFLX) stock has fallen since its July 2011 levels of approximately $300 and has left investors with a bitter taste in their mouth. The last two years have transformed Netflix from a mainstream DVD rental provider to an online movie streaming leader, ahead of relative newcomers such as Amazon (AMZN), Dish Network's (DISH) Blockbuster and Comcast's (CMCSA) Xfinity Streampix. However, management's poor decisions and communication regarding pricing and product changes have left Netflix struggling with subscriber defections.
Our current price estimate for Netflix stands at $96, implying a premium of about 50% to the market price. Our thesis is centered around Netflix's lead in streaming domestically and its international prospects.
Image Re-Building In Process, Streaming Subscriber Gains Have Begun
Netflix's U.S. quarterly subscriber additions, which grew 61% in 2010 and 255% in early 2011, started to decline when the company announced a price increase and a re-branding of its DVD business to Qwikster. Since then Netflix has been making efforts to re-build its image and turnaround its subscriber trends. As a result, the first half of 2012 saw healthy streaming subscriber additions when Netflix gained close to 2.27 million streaming subscribers in the U.S. alone.
The company's long-term vision is to transition to a pure-play streaming company and investors need to watch out for competition in streaming arena rather than worry about DVD declines.
Netflix commands close to 25% share of roughly 85 million U.S. broadband households and about 20% share of the U.S. pay-TV households. This implies a significant reach and given the early mover advantage, an opportunity to expand further.
Content Advantage is Still High
Despite the setbacks in 2011, Netflix still enjoys a significant competitive lead over some of the similar services such as Amazon Prime and Blockbuster's streaming service.
Netflix has a much better online streaming library compared to these competitors and has been consistently striking deals to enhance its offering. Bigger competitors such as Amazon and Dish will still have to work hard to catch up with Netflix. In fact, Dish Network confessed during one of its earnings announcement that making content deals has been a challenge for the company. We think that given the content advantage that Netflix has, it will be able to sustain subscriber growth in the U.S.
International Prospects Are Undervalued
We estimate that the international streaming business accounts for about 25% of our price estimate for Netflix. We believe the market is not fairly valuing Netflix's prospects in international markets perhaps because of high content costs that the company will have to incur for several more quarters, low per capita income and low credit card usage in Latin America, and a limited market size in Canada. In addition, investors are worried about competition in some of these markets, particularly in the U.K.
On the contrary, we believe that Netflix has a fair chance of success as initial results have been good. Netflix now has close to 3.6 million international subscribers, out of which roughly 1.8 million were added in first half of 2012 alone. This demonstrates that momentum is picking up in international markets. The broadband penetration in Latin America, although low, is on the rise and the market potential is huge. DirecTV's success in Latin American markets such has Brazil demonstrates that advanced services such as Netflix's movie streaming have a high probability of gaining adoption in the region. Additionally, the company is looking to launch in another undisclosed international region at the end of 2012, thus expanding its coverage beyond the U.S, U.K., Ireland, Canada and Latin America.
Key Risks: International Failure, Competition Intensifying, Content Costs Soar
One of the primary risks to our price estimate is the possibility of international expansion slowing. Although we remain optimistic about these geographies, there is a possibility that Netflix does not gain traction in these regions. Stiff local competition in the U.K., as well as low per capita income and lack of credit card usage in Latin America, could potentially slowdown Netflix's international expansion significantly. We estimate that such a slowdown could have a negative impact of about 20% to our price estimate due to low international streaming subscriber growth. The slowdown will not only affect subscriber gains, but also the company's potential profitability in these regions.
Furthermore, if Amazon and Dish really throw their weight into streaming and other competitors such as Verizon take on Netflix in the domestic market, the ensuing content bidding war could have a two-fold impact on Netflix. First, it will lead to higher content acquisition costs causing margins to shrink. Second, it would lead to content diversification, thus eroding some of the content advantage that Netflix currently has. This could lead to a slowdown in the company's expansion in the U.S. market. Such a scenario could add another 20% downside to our current price estimate.
Disclosure: No positions.