Netflix: What If It Hits 375 Million Subscribers?

Summary

• Several analysts are touting that Netflix will gain substantial international subscribers.
• Netflix has the potential to hit 300 million international subscribers by 2028, notes Morgan Stanley.
• Simplistic relative valuation will make you believe that Netflix is cheap.
• However, detailed valuation reveals that the stock is priced for perfection.

As Netflix (NASDAQ:NFLX) is closing in on its first earnings of the year, analysts have started to weigh-in on the company’s outlook. Both Morgan Stanley and JP Morgan have raised their price target for Netflix amid prospective international growth. Goldman Sachs is also painting a rosy picture as far as the results of the quarter are concerned. Netflix is expected to report the earnings of its first quarter on April 16.

Analysts at Morgan Stanley think that Netflix will benefit from the growth in international markets; they raised their price target to $300. JP Morgan is even more bullish with a new price target of $328, an upside of ~8% to the Wednesday’s close price. Goldman is ahead of the pack with a $360 price tag on Netflix; they also cite global scale benefits among the reasons for their price target. The theme around analyst report is common, global reach and network of Netflix. However, there is one particular problem for Netflix – content costs.

Netflix’s business entails very high variable costs.

The content-intensive nature of the business makes us skeptic about the future earnings potential of Netflix. The company is expected to spend $7.5 billion-$8 billion on content during the current year. To put it in perspective, revenue forecast for the year stands at $15.9 billion; the company is practically spending half of its revenue on content.

However, the growth of revenue has started to surpass the growth in cost of sales. See the chart below:

Source: NFLX shareholders’ letter 2017

The company managed to pull down its cost of revenue by 200 basis points during 2017. Nonetheless, the cost of revenue is very high in absolute terms, given the sky-high valuation of Netflix.

The problem of content acquisition is not going away.

The problem with the content acquisition model of Netflix is twofold. Firstly, the company is not getting perpetual rights to the external content it acquires; the content expires after some time.

“We acquire, license and produce content, including original programming, in order to offer our members unlimited viewing of TV shows and films. The content licenses are for a fixed fee and specific windows of availability.”

- an excerpt from 2017 annual filing

Secondly, and more importantly, current subscribers aren’t going to be satisfied with existing content; the company must produce continuously to sustain its user base. Of course, Netflix knows that. The chart below clearly depicts the cost intensive nature of Netflix’s business.

Source: NFLX Shareholders Letter Q4 2017

For domestic and international streaming segments, amortization of the streaming content-assets makes up the vast majority of the cost- of-revenue of Netflix. It can be seen in the chart above that the amortization expense stood at more than $6 billion in 2017. In other words, Netflix has to spend more than $6 billion in order to sustain its library of content, let alone grow it. The high amortization, or the rate of expiry of content, is one of the reasons that the company grew its content asset-base by only ~$2 billion during 2017 despite spending around $6 billion dollars on content.

The point of mentioning the accounting jargon is that content spending isn’t going to slow down going forward. The company will have to spend more if it wants to grow its content base, or it has to spend at least equal to the amount of its amortization to sustain its library and create original content.

Overall, it’s perfectly clear that Netflix will continue to be high variable-cost business, thanks to content costs.

Now, to the important question, how much does Netflix worth with its high variable-cost business?

This question is open to interpretations and is highly sensitive to assumptions. With its content spending frenzy, Netflix has managed to show astonishing subscriber growth. But, it is yet to be seen whether this growth translates into material bottom line for the company, or not? Nevertheless, to answer the question, we attempted a simple and a detailed valuation of Netflix based on several loose assumptions below.

1. Simplistic valuation

Assuming that Netflix achieves 100 million subscribers in the U.S. and 300 million internationally, we got the following revenue projection.

*APRU is derived by dividing the revenue of 2017 by number of subscribers at the end of 2017. Plateau of 100 million is used, which is based on the assumption that all US households with a pay TV subscription will eventually subscribe to Netflix. 300 million international subscribers for Netflix are used based on the assumption that global pay TV subscribers (excluding APAC) will eventually subscribe to Netflix’s service.

Plateau assumption, although optimistic, are still possible. According to Statista, more than 99 million households subscribed to a pay TV in the U.S in 2015. This figure has come down to 94 million since then.

Number of pay TV households in the U.S. 2017 | Statistic

Nielsen reports that more than 119 million U.S. households own a TV in 2017-2018. According to Leichtman Research Group., 88% percent of the U.S households subscribed to some type of Pay-TV in 2010. Based on this data, a 100 million subscriber-base cap in the U.S is a reasonable assumption for Netflix.

Global Pay-TV subscribers touched 1.07 billion by the end of Q3 2017; Asia Pacific accounted for more than 62% of the total Pay-TV subscribers. Backing out the U.S. and APAC Pay-TV subscribers, there are still more than 300 million Pay-TV subscribers around the globe. Therefore, a saturation point of 300 million international subscribers is plausible for Netflix.

The second assumption is that Netflix will continue to add subscribers if it maintains its content base while adding fresh original content. The very minimum requirement for Netflix to achieve that is to spend at least equal to the content amortization costs (around $6 billion) each year.

*Operating costs, interest rate and tax rate assumptions are based on full year results of 2017. Invested Capital is proxied by the balance sheet shareholder capital at year ended 2017. Cost of Equity is assumed at 8%. Note that the valuation is based on the assumption that Netflix will maintain the profit after tax in perpetuity.

The simplistic version of valuation reveals that if Netflix achieves 100 million subscribers in the U.S and 300 million additional subscribers internationally, it has an upside of ~57% over Wednesday’s close price.

Note that this is conditional on the assumption that the company will invest a minimum of $6 billion p.a. on content perpetually. In short, there is an upside if you believe that the stock can hit 400 million subscribers in total.

However, there are several short comings in this simplistic version of valuation. First, it’s hard to say how long will it take for Netflix to hit the 400 million subscriber mark. The longer the company takes, valuation should naturally go down amid discounting. Let’s assume Netflix takes five years to reach the 400 million subscribers milestone. “Market Value Added” in the above valuation sheet will go down to $170-$180 billion, limiting the upside. But, that’s not all. Netflix is not spending $6 billion on content, it’s spending more. Therefore, precise valuation should be lower than what’s calculated above. Finally, there’s is the question of ARPU from emerging economies. As Netflix grows, ARPU will come down. Overall, the simplistic version of valuation is not very reliable.

2. Detailed Valuation

Let’s now try to forecast the path towards subscriber growth. If Netflix continues to grow its U.S. subscriber base, it will reach ~96.1 million by 2023 (based on the assumption of 10% growth in subscribers each year). International subscribers are assumed to reach around 279 million by 2023, assuming a 30% growth in subscribers for the next five years. Note that the company grew its domestic subscribers by around 10% during 2017 while spending $6 billion on content. It follows from this, that the company will sustain such a growth rate if it continues to spend the same amount of money on content.

*The growth forecast, both in the U.S. subscribers and international subscribers, is in line with the subscriber growth of 2017. The primary assumption backing our growth assumption is that content spending will keep the growth rate intact going forward.

*ARPU of $116.5 and $88 is derived by dividing the revenue of 2017 by number of subscribers at the end of 2017.

*Operating costs, interest rate and tax rate assumptions are based on full year results of 2017.

Focus Equity Estimates

EVA valuation reveals that the stock is priced for perfection, and this will be the case if Netflix continues to post 10% p.a. growth in U.S. subscribers and 30% p.a. growth in international subscribers until 2023 to reach a total of ~375 million subscribers. All in all, although Netflix seems attractive from a simplistic perspective, the simplistic version ignores the time taken by Netflix to achieve such a high number of subscribers. Detailed valuation with similar assumptions shows that the stock is priced for perfection at best.

Closing remarks

Netflix is a content intensive business with a high variable-cost structure. The company has to continuously spend on content in order to retain subscribers. Even if Netflix manages to hits the 375 million subscriber mark, the valuation can’t be stretched much. On a side note, we think it might be an uphill battle for Netflix to gain subscribers at a high growth rate and hit a 400 million mark quickly. You can read our detailed take on this argument here. Anyhow, the reward/risk seems skewed towards risk as Netflix should reach 375 million subscribers, just to justify its current valuation.

Analyst’s 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.

This publication is for informational purpose only and reflects the opinion of Focus Equity’s analysts. This opinion doesn’t constitute a professional investment advice. Our senior technology analyst, Soid Ahmad, compiled this research piece. Focus Equity is a team of analysts that strives to provide investment ideas to the U.S. equity investors.