Quick Thoughts: Netflix – The Dream is Alive!

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–        All good news from NFLX for 4Q – beats on subs and earnings, bullish guidance, aggressive plans for international expansion, and pricing tiers – drove the stock up 15%+ after hours

–        Subs were up 36.5% YoY to 41.4M on 3.4M net adds, 2.3M in the US. Guidance for 1Q14 calls for another 4.8M net adds, which would raise subs to 35.5M US and 10.7M abroad

–        The strong sub #s and profitability validate NFLX’s content strategy, with significant room for further sub growth and additional ways to monetize, e.g. enhanced subscriber offerings

–        VZ’s legal win vs. Net Neutrality regulation is a dangerous precedent, but NFLX is not concerned near term. Longer term, we expect wireless broadband competition to keep ISPs in check.

Hot on the heels of 3 Emmy wins, a Golden Globe, and an Oscar nomination announced just last week, Netflix delivered another quarter full of upside, beating consensus handily with EPS of $0.79 versus $0.64 consensus, a slight topline beat of $1.18B in revenue versus $1.17B expected, and paid streaming additions of 3.4M where midpoint guidance suggested 2.8M adds. Netflix’s own guidance for 1Q 2014 is bullish calling for a total of 4.8M streaming adds including 2.55M Domestic and 2.25M International. I believe it can meet and beat its own guidance largely driven by growing numbers of connected streaming devices, its investments in original programs, international expansion, and new monetization levers like streaming plan segmentation.

While Netflix doesn’t release data on the successes of its original series, the best proxy for success is critical acclaim, of which there was no shortage this awards season. House of Cards picked up Emmy and Golden Globe wins, and the company could hit an awards trifecta should “The Square,” a documentary on the Egyptian revolution win an Oscar, although Grammys and Tonys are probably out of reach. In all fairness, Netflix isn’t the production company behind its originals, but bankrolls production and buys exclusive rights in a similar manner to the way Hollywood studios operate. It funded and acquired exclusive distribution rights to “The Square” and “The Short Game” last year. It also acquired streaming rights to 3 of the 4 other films nominated in the Best Documentary category, so the odds of a film distributed by Netflix winning an Oscar are certainly in its favor. Aside from critical acclaim, Netflix has also signaled success of its originals by announcing renewals for future seasons of House of Cards, Hemlock Grove, Orange is the New Black, and Lilyhammer, with the latter currently filming its third season. It also has inked deals with AMC to show the entire Breaking Bad series and rights to spin-off Better Call Saul in certain markets.

With content driving viewership, Netflix has also been experimenting with pricing plans, testing a $6.99/month single screen option and a $11.99 family plan for four simultaneous streams as alternatives to its standard $7.99/month two stream subscription. Netflix may also consider segmented pricing for standard definition, HD, and 4K subscriptions for new customers, but has pledged that existing viewers will get access to the higher resolution signals with their current subscription plan.

In addition to tweaking pricing to maximize revenues through segmentation, Netflix has other monetization levers at hand. International expansion offers considerably more future growth – to date, Netflix has just harvested the low hanging fruit – like Latin America, where content rights are typically bundled for multiple countries, English-speaking countries like the UK and Ireland, which naturally consume American content, and Nordic countries like Norway, Denmark, and Sweden which have few restrictions on foreign content and English language programming is only sometimes dubbed. With just under 10M paying international members across 41 countries with a total population well in excess of 500M, Netflix has a penetration of less than 5% of its addressable non-US households. While CEO Reed Hastings has regularly rebuffed suggestions of pursuing ad-driven or live content strategy, Netflix can also get more creative with pricing and segmentation with Pay Per View options, movies for download, or even premium content tiers. The company has solidified its first mover advantage and continues to have plenty of runway to grow.

With last week’s net neutrality ruling by a US Court of Appeals in favor of Verizon against the FCC, Netflix stock fell about only about 230 basis points, signaling investors haven’t bought into a doomsday scenario of all-powerful broadband carriers. Reed Hastings also downplayed the ruling in the investor webcast. While plaintiff Verizon would like to regulate content streaming on its wireless networks to control bandwidth congestion, it is unlikely to throttle services on its high speed FiOS offering without significant consumer backlash and unwanted government attention. Comcast, the largest US cable provider, has to follow net neutrality rules until 2018 per the regulatory agreement that allowed it to acquire NBC Universal in 2011. I expect by then that US broadband will be more competitive, with high speed LTE advanced wireless broadband services likely rivaling traditional residential broadband in cost and performance before the end of the decade.

Value investors will keep on hating Netflix, but Netflix is going to keep on delivering serious growth – enough to keep the dream alive for the foreseeable future.

For our full research notes, please visit our published research site.

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