When Netflix (NFLX) reported its last quarterly earnings, we found out that the company planned on entering a new market later in 2012. We don't know the official launch date and pricing yet, but we do know the where. Netflix announced last week it would be launching into four new countries: Norway, Denmark, Sweden and Finland. This move comes at a time where the company had just regained global profitability after the launch into UK and Ireland, which will now probably put Netflix back into the loss column in Q4 and maybe during the early parts of 2013. Let's break down the move.
Analyzing the Size:
This is not a large scale move for Netflix. According to the most updated numbers, the four countries mentioned above have a total population of about 25.5 million. How big is that comparatively speaking? Well, it's not much. That's basically equal to the size of Texas in the United States, in terms of population. In terms of Netflix comparisons, it would be the fourth largest "market" for Netflix, when adding these four countries as a whole. The United States has an estimated population of over 314 million, the UK (which Netflix recently entered) is over 60 million, and Canada even has about 35 million.
This might be a slight disappointment for Netflix bulls, who were maybe hoping for an entry into a country like Germany (roughly 82 million people) or France (about 65 million). But it is certainly a bigger move than just moving into one of those four names.
Netflix had about 24 million total US streaming subscribers at the end of Q2, of which, about 22.7 million were paying customers. Since Netflix has been in the US for a number of years, I think you can use that as a figure for this launch. Right now, about 7-8% of the total US population are "subscribers", and a subscriber could be an entire household, which could be several people.
Here's how to look at things. Netflix announced on Monday that it hit one million subscribers in the UK and Ireland. That took about eight months to do, and the population of the UK and Ireland is about three times that of the four countries they are entering. At that pace, it will take Netflix about two years to get 1 million subscribers from these countries. That's not exactly quick.
This is expansion, don't get me wrong, but this isn't a move that will really move the needle, in my opinion. Even if you use US pricing ($8 per month), a million subscribers only generates $96 million in revenues per year. This is not a lot when looking at the current estimate for Netflix 2012 revenues of $3.61 billion.
The impact on profitability:
Netflix decided to move to a lower margin business when it essentially started the death of its DVD segment in 2011. At the same time, international expansions are costly. The following table shows Netflix's margins over the past eight quarters.
The first half of 2012 has seen some dramatic margin declines, and this is to be expected. When your focus is on streaming, which is running a contribution margin in the high teens, and not on DVD, which ran a 50% plus contribution margin, now in the mid 40s, margins are going to fall. Add in the losses from the international business, and you're not going to be very profitable, maybe not profitable at all.
Gross margins will be under pressure for a while, and I don't see Netflix as a company that can just decide to cut a ton of operating costs out of the blue, so expect operating margins to stagnate as well. Yes, Netflix can probably get profit margins back into the low to mid single digits over time, but not while it keeps expanding.
The excuses
Nobody likes a person that always complains, and investors are getting tired with the management behind this company. If you don't believe that, just look at the share price that has dropped from over $300 to barely above $50 recently.
It was Netflix management that decided to raise prices tremendously. It was management's decision to spin off the DVD business, then not spin it off, then decide to kill it, then bring it back. It was Netflix management that said that Q2 results would be impacted by seasonality, and that Q3 results would be impacted by the Olympics. This is the same company whose CEO bragged about viewing hours in June, forgetting that viewing hours don't necessarily mean more subscribers. The same CEO who just bought $1 million worth of stock, not in his own company Netflix, but in Facebook (FB). Yes, Reed is a member of Facebook's board, but what a vote of confidence for Netflix. One week into things, and Reed has lost about 10% on his investment.
This is the same company that changes how it presents its financials basically every quarter, so trying to compare one period to another can sometimes be either impossible, or just take a while. But with all of the whining they do, I would not be surprised if they say Q4 will be weak because people will be doing holiday shopping and not watching Netflix. If they come out with another excuse this time around, I can only imagine what the response from the market will be.
The competition is there:
While you can listen to any Netflix earnings call or read any investor letter and see how Netflix doesn't see any real competitors, people like me actually see the competition.
A good example is the Verizon's (VZ) joint venture with Coinstar (CSTR). The two companies have begun testing their digital video project recently, according to company sources. The joint venture will provide another streaming option for consumers, based off the Redbox DVD service that Coinstar already operates.
What does Netflix have to say about this? Well, the following quote is taken directly from the Q2 investor letter.
Redbox Instant by Verizon, once they launch, will face a big challenge to break into the top 3 of subscription streaming services.
So what if they don't break into the top 3, at least not right away? Competition is competition. Netflix needs to hold every current subscriber and gain new ones. Any challenge to that is an issue. Sure, Coinstar/Verizon's partnership probably won't have 20 million subscribers in two years, but even if they steal a few hundred thousand or a couple million from Netflix, it does take a chunk out of Netflix's growth plans.
Netflix made a big push into the UK earlier this year, where they didn't see a lot of competition. However, BSkyB has launched their NowTV streaming service. While Netflix correctly points out that NowTV is more expensive, BSkyB plans to add more than just movies to the service, including various sports and other entertainment.
Netflix's other competitor in the UK is LoveFilms, which is a subsidiary of Amazon (AMZN). Yes, the same Amazon whose Prime services allows you to stream movies and other content online. Amazon's only concern right now seems to be increasing its revenues, so they will be a serious player in this space, even if its not very profitable for them right now.
Conclusion - Another so-so move:
Sure, Netflix is expanding into more countries, but this isn't the large scale move bulls may have been hoping for. With the launch scheduled for later this year, there probably won't be too much impact on 2012 numbers, the real impact will be felt in 2013. The competition is also growing, and we are getting closer by the day to the Coinstar/Verizon launch of their new service. Plus BSkyB and Amazon are here to stay. Netflix needs to prove itself in the next few quarters, and that means no excuses for why things may not be going exceptionally well.
As for the stock, I noted in past articles that I expected at least a $10 bounce once the stock hit a new low. Well, Netflix hit a 52-week low recently of $52.81, and had rallied about $13 at Friday's high before dropping two bucks into the close. Netflix shares are up more than 20% from the low. They could rally a bit more, but the valuation argument does not make sense here because the company's profitability isn't really viable (every time they become profitable, they probably will expand internationally again). I still am not a long term fan of this name, and the move into Scandinavia doesn't exactly have me running out to go long this name.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
