Netflix Bears Are Wrong On Content Costs And Subscriber Churn

About: Netflix, Inc. (NFLX)
by: Alex Cho

Perceived risks over subscriber churn were overblown.

Investors should focus on long-term scale advantages from in-house content and leveling off of show license costs.

When quantifying the necessary content catalogue for a viable streaming service I believe gross margin expansion can be sustained.

Therefore, content costs will increase, but we’re reaching that key inflection point where Netflix can sustain enviable margins in the next 10 years.

In the month of December, I published an article that rationalized Netflix's (NASDAQ:NFLX) valuation. In response to the article, many in the comments section were very critical. So, I have written an article to clearly refute the top bearish NFLX arguments.

The challenges cited by bears could be simply be summarized as: churn, rising cost, net neutrality and competition.

Some also mentioned that churn was another risk factor. Coming out the prior quarter, we have already confirmed that the price increase did not negatively affect NFLX's current base of subscribers too significantly, given the limited impact on Q3'16 earnings, which is when Netflix fully implemented the new prices for grandfathered subscribers (I was one of those grandfathered subscribers).

The q/q subscriber growth in the United States was 160k and 370k in Q2'16 and Q3'16 respectively, versus growth of 900k and 880k for Q2'15 and Q3'15 respectively. The shift to the higher pricing tiers negatively impacted subscriber growth by 1.25 million units when based on historical q/q trends.

When dividing that figure into Netflix's total subscriber count for Q3'16, the churn rate was appx. 2.6% above historical trends, which was way better than what the analyst consensus was modeling/forecasting going into Q3'16. I saw figures hover at around 3% to 5% for churn based on initial survey data, but the reported financial data was better.

Furthermore, the Q4'16 guidance for 1.45 million subscriber growth compared favorably to Q4'15 subscriber growth of 1.56 million. NFLX's domestic subscriber ramp is set to stabilize, or revert to the mean. So, the momentary blip in subscriber data for Q2'16 and Q3'16 was likely temporary, therefore, suggesting growth will return to the mean regression rate (barring unforeseen externalities).

Investors who sold shares on perceived risks from price increases misread the entire situation. Now, NFLX is in a better position to recapture content costs with its now-elevated tiered pricing structure. The cost of content tends to increase linearly, but the adoption of higher-quality streams is likely to be exponential with costs of hosting and storage trending downward given AWS (Amazon Web Services) price reduction at appx. 5% per annum (given Amazon's (NASDAQ:AMZN) latest announcements). Netflix's uses AWS Elastic Compute and Storage exclusively, so its IT costs will certainly decline over time.

Netflix's content library is expected to increase over time, but the cost per programmable hour can be managed to higher levels of efficiency depending on genre. Obviously, highly expensive war-themed series like Marco Polo could prove difficult to scale, whereas crime thrillers like House of Cards are much more economical with a stronger base of mainstream appeal.

I'm forecasting Netflix will spend $13.3 billion on content licensing and original programming by FY'20. In FY'16, I project NFLX spends $5.8 billion on content of which $1.1 billion or 19% was spent on Netflix's in-house productions (UBS estimate). If original programming shifts to 50% of Netflix's total content budget (which it likely will) by 2020, Netflix can produce 3,325 original programming hours or 166 different TV season at 20 episodes per annum. This is more than enough content for its global audience, regardless of language barriers and segmentation of preference.

Who could honestly follow more than 10 to 20 TV series in a year?

Netflix's content costs ramped due to the licensing of Walt Disney films, inclusive of Marvel, Lucas Films and Pixar. Strict content licensing isn't going to increase much further upon the full phase-in of the Disney licensing agreement, because there's not a single movie publisher that's more dominant at the box office, or has more pricing power globally. So, if Netflix is under an exclusive contract to pay several hundred million dollars (reportedly) then the cost of content licenses is more distributed towards foreign titles (which are cheaper to acquire), and the need for more original programming (arguably the most cost-effective method).

NFLX's contribution margin has trended higher, as original programming paired with the upfront cost of Disney, Sony, Warner Bros., CBS, DreamWorks, AMC, and various other TV/Movie studio licenses are leveling off.

Netflix's shift towards cheaper in-house show productions should translate into a more linear cost ramp that's far more controllable at roughly $30 million per original season (some will cost more while others will cost less, but will likely average out at perhaps $30 million to $50 million depending on season length and genre). This will contribute to NFLX's profitability, because it doesn't need to produce more than 5,000 original programming hours (costing $10 billion/annually), or license more than half of the Hollywood box office hits to make a viable streaming product.

Hence, I'm not worried about economies of scale or long-run cost dis-synergies, because I don't see them emerging. I'm also not worried about the perceived risks over subscriber churn, which I will explore in more detail in my next article.

I continue to reiterate my high conviction buy recommendation and $144.46 price target.

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.