Despite its high-growth, high-valuation status, Netflix (NASDAQ:NFLX) has a sharply negative near-term growth outlook. This is before any news on possible price competition from some of its heavyweight competitors and the fact that its business model is increasing in complexity. The risks are mounting.
Managing the three segments - harder than it looks - the greatest threat to investor's capital
Although Netflix is viewed by most investors as a highly successful streaming video service, it actually has three moving parts.
Firstly, the US domestic streaming business, which is currently enjoying high growth and expanding margins. Secondly, is the US DVD business, which is mature in nature and high-margin, but in secular decline (it relies upon the US postal service to deliver DVDs to consumer's homes). Thirdly, the International Streaming business, which is very high growth, but requires heavy capital investment and is currently operating at a loss.
I believe managing these business segments simultaneously is the key challenge management faces presently, while of course being mindful of heavyweight competitors such as Amazon.com (NASDAQ:AMZN), Home Box Office (HBO, owned by Time Warner (NYSE:TWX)) and Google's (NASDAQ:GOOG) (NASDAQ:GOOGL) YouTube, who may decide to 'buy' market share at any time. Despite management's optimism, it's likely that as the business grows, managing these segments will become increasingly complex, which I view as the greatest threat to investor's capital.
Disappointing Q3 subscriber growth in US Streaming, the Q4 number of 1.8 million net additions is key
Netflix has reported strong subscriber growth for the past few years. As of Q3-14, the company had 37.2 million US (domestic) streaming subscribers (+20% y-o-y), 15.8m International subscribers (+72% y-o-y) and 6m domestic DVD subs (-16% y-o-y). The Q3-14 US Streaming growth rates were disappointing however (subs down 25% on Q3-13). Management attributed this to the May 2014 price increase (new subs now US$ 8.99/ month, with existing subs grandfathered in at the old rate of US$ 7.99 for two years). Looking to Q4, expectations are for net domestic Streaming subscription additions of around 1.8 million, which will be one of the key numbers in the Q4-14 earnings release, but could still be too high (consensus was 2.2 million previously) due to the continuing impact of the price rise earlier this year.
International growth outlook is good, but at what price?
Netflix's International business is experiencing strong subscriber growth as the company expands into new countries, such as Germany and France since September 2014. But the cost of this expansion is high in terms of the capex requirement and this business remains sharply in the red. Unquestionably the potential for growth in new subscribers is high in these new, international markets. However, so is the potential for sharply increasing subscriber acquisition costs and thus on-going negative margins, especially if price competition heats up in FY'15 and beyond.
Q4-14 EPS estimates are sharply down sequentially and y/y, with H1-15 similar
Despite the "high-growth label," which has been attached to NFLX's earnings profile, the near-term profile is decidedly negative. Q4-14 earnings estimates (under GAAP) are for around $0.45 per share, which represents a year-over-year decline of 44%, plus a sequential EPS decline of 53%. There are some reasonable explanations for this decline, but hey, the first two quarters of FY'15 are also likely to be quarters in which the reported EPS growth rates are sharply negative year-over-year. With this grim near-term outlook for Netflix's earnings, plus capex increasing and the threat of Amazon becoming very competitive in US Streaming in FY'15, I believe NFLX's share price will remain under pressure. I show my current Levered Returns model below:
Netflix's business model is becoming more complex as the international growth strategy gains pace. Recent subscriber growth numbers in the key US domestic streaming business have been disappointing and all eyes will be on the Q4-14 figure. Near term the quarterly earnings per share outlook is decidedly negative, which will influence sentiment in the stock. Thus, with little positive news likely near term and my DCF showing NFLX is overvalued on a longer-term basis, I expect the share price to fall toward my price target of $290 a share.
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