As Netflix (NASDAQ:NFLX) reports its Q3 2012 earnings on October 23, investors will be "hoping" for accelerated streaming subscriber gains and reduced DVD subscriber losses. The opposite was true last quarter when DVD subscriber losses overshadowed streaming gains, resulting in net loss of subscribers in the U.S. We believe that Netflix could potentially fall short on its subscriber guidance for the year and may revise it during the upcoming earnings release. We expect DVD losses to continue but come down slightly on a sequential basis. The streaming additions should go up compared to Q2 due to seasonality, but the extent of increase will remain moderate. Overall, we do not expect a positive surprise from Netflix and remain cautious about our expectations.
U.S. Subscriber Growth Will Remain The Key
Whether or not Netflix can reach its guidance of 7 million net domestic additions this year is something that investors should keep an eye on. Given that the company has gained roughly 2.1 million in the first half of 2012, reaching 7 million seems like a long shot. We expect Netflix to lower its guidance, but that may not necessarily mean disaster. It may just mean that the company is taking a little longer to recover from the issues it faced in 2011.
It is troubling for Netflix that not only several strong competitors such as Comcast (NASDAQ:CMCSA), Amazon (NASDAQ:AMZN), Verizon (NYSE:VZ) etc. have sprung up, but also that it has lost some of the content due to issues related to renegotiation of prices. This and due to the fact that Netflix has not made any major move in the recent past, we expect U.S. subscriber growth to remain slow.
Amazon is Netflix's closest competitor currently. As far as content is concerned, Amazon had over 22,000 titles in its streaming library in August 2012, representing 70% growth in 2012 alone.  The company further signed a deal with Epix in September to add 3,000 more titles to its library, bringing its total to 25,000.  Amazon's device reach isn't bad either and subscribers can watch the content on TVs, Blu-ray players, Kindle Fire, PS 3, Xbox 360 and iPad.
However, we have our doubts regarding Amazon's motivation of continuously improving its streaming content. The fact that Amazon is unwilling to separate streaming as a stand-alone service indicates that the Amazon's primary motive is to promote its online sales by encouraging customers to subscribe to its Amazon Prime service. This is the right strategy as, after all, Amazon's core business is online retailing. Nevertheless, this could also mean that Amazon may not put enough effort in improving its streaming catalog, and keep it just good enough to lure customers to take advantage of free shipping along with some add-on video entertainment.
Margin Pressure Will Continue, Expanding Internationally Too Fast
The content cost will remain high as Netflix seems to be getting too aggressive in international expansion. Beginning with Canada in the last quarter of 2010, Netflix has expanded to Latin America, the U.K., Ireland and recently Scandinavia (Norway, Denmark, Finland and Sweden). While expanding internationally makes sense, margin pressures will continue unless Netflix can substantially increase its international subscriber base. We believe that most of Netflix's content agreements are not based on revenue sharing and, thus, the company has good amount of operating leverage. This implies that, as the subscriber base grows, its margins will improve significantly. Until then, Netflix is taking a substantial risk.
Our price estimate for Netflix stands at $96, implying a premium of about 50% to the market price.
- Amazon Prime Crosses Big Milestone: More Items Are Now Shipped with Prime Free Two-Day Shipping Than with Free Super Saver Shipping, Amazon Press Release, Aug 27 2012
- Amazon and Epix strike movie deal; Netflix shares drop, Reuters, Sept 4 2012
Disclosure: No positions