Quick Thoughts: Netflix is the New Black


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–          NFLX posted 3Q13 upside surprises for subs and earnings, and promised more of the same for 4Q13 – no surprise, the stock is up big after hours.

–          Global subs are up 36.7% to 40M, US subs up 24% to 31M. Subs can keep growing with expanding TV connectivity, shifting viewing habits, and new markets.

–          Profitability can continue to improve with scale despite the need to invest in content, particularly if NFLX can leverage investment globally.

–          Longer term, current success opens future opportunities for further monetization despite management reticence to acknowledge the possibility.

Netflix is in the right place at the right time. As device makers trip over themselves to get next generation TV solutions into the market, Netflix is the must-have tent pole service for all of them. At the same time, the company’s original programming made a big splash in the public consciousness – “House of Cards”, “Arrested Development” and “Orange is the New Black” have been big trending topics on the electronic Twitter and Facebook water coolers. “House of Cards” delivered the first three Netflix Emmys, while “Breaking Bad” creator Vince Gilligan credited the streaming service for building the audience for his award winning drama. People know about Netflix, they want Netflix, and, increasingly, they can get Netflix on their living room TV.

Investors know about Netflix too. The stock is the number one performer in the S&P500 YTD, with afterhours trading pushing the share price to $390, a six-fold increase YoY. To keep it going, management will have to find more growth and raise margins. Despite the lofty multiple and the associated expectations, I think the pleasant surprises are not all behind us.

The subscriber rolls can get a lot bigger. Only 29% of US multichannel households are paying Netflix subscribers. The proliferation of devices that can stream content will pave more runway for the service. Netflix is already available on most internet enabled TVs, blu-ray players, and comes as a default app on streaming devices like Google’s Chromecast and Apple TV. Next generation game consoles and set top boxes that plug directly into input one are coming out in the next month giving those devices more leverage in the living room. Cable boxes are also getting better, with Comcast’s X1 demonstrating a faster interface with an ability to run apps. Netflix has been rumored to be in talks with cable MSOs to offer its service on cable boxes and Hastings didn’t rule out that the service could be on his Comcast X1 box at home. Netflix’s ubiquity across devices will drive growth.

Then there are international markets. While Netflix is available in about 40 countries, only a few of those are major broadband markets – the US, UK, and Brazil. The others are generally smaller, low risk countries – like Canada, Ireland, Scandinavia, and the Netherlands. However, the company sees substantial opportunity in Latin America, a huge contiguous market with a common language and a rapidly expanding broadband base, which is expected to grow larger than the US within 5 years. Furthermore, there are still many international opportunities in major broadband markets like Japan, Germany, France, Korea, Russia, India, etc. Continued international growth in the mid-double digits is a reasonable assumption.

The service can be more profitable. It’s estimated about one in three accounts shares passwords and the company can begin to enforce stricter account policies that prevent account sharing. Reining in on such users could be worth over $200M in extra revenue each quarter, but carries a risk of alienating the Netflix customer base. Any crackdown would have to be subtle as the memory of Netflix’s failed pricing changes in 2011 and subsequent fall in share price still haunts Hastings. The company does offer upgrade options to family plans priced at $11.99 and more aggressive marketing of this service level could drive revenue.

The service can also control for original content costs. Netflix’s critically acclaimed original content and Emmy wins have made the service a favorite destination for content creators to shop content. Showrunners are now known to approach Netflix before taking pilots to major broadcast networks. Without fears of midseason cancellation and liberal creative control policies, producers prefer to work with Netflix in turn giving the service a robust pipeline of projects with favorable terms that can positively affect margin.

But Netflix need not just rely on subscriber growth and margin expansion. It can leverage its success into other services – premium tiers, live events, advertising driven formats, pay per view, etc. – even if management is saying no right now. Expectations are doable, so even the lofty valuation may not stop the momentum.

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

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