Netflix's International Expansion Will Be Expensive

Netflix (NASDAQ: NFLX  ) stock has soared this year as investors have cast aside doubts and embraced its disruptive growth potential. The company has dramatically improved its profitability and is on pace to deliver EPS of about $2 in 2013, excluding a debt retirement charge of $0.26 per share from earlier this year. Analysts currently expect earnings to double again next year.

But with profitability recovering, Netflix is looking to pick up the pace of its international expansion. In 2012, Netflix entered several new European markets: the U.K., Ireland, Denmark, Norway, Sweden, and Finland. By contrast, in 2013 Netflix has entered just one new (and relatively small) international market: the Netherlands.

International growth, if successful, could be very valuable for Netflix. But entering a new market entails significant start-up costs, which are roughly proportionate to the size of the market. Netflix investors are currently hoping for rapid revenue growth and rapid profit growth. But entering major new markets will create a significant drag on earnings, despite boosting revenue. Netflix investors may thus be setting themselves up for disappointment.

The cost of expansion
Over the past two years, there has been a pretty clear correlation between Netflix's entry into new markets and spikes in its international losses. In the first quarter of 2012, Netflix entered the U.K. and Ireland, and the quarterly international contribution loss spiked from $60 million to $103 million sequentially.

Netflix's entry into the Nordic countries in the fourth quarter last year was accompanied by a smaller jump in the international contribution loss, from $92 million to $105 million. Again, when Netflix began serving the Netherlands last quarter, it was accompanied by a sequential increase in the international contribution loss.

While these numbers are "choppy," the impact of expansion on profitability is significant. If we just look at this year, Netflix reduced its quarterly international contribution loss by $39 million in the first half of the year. By contrast, Netflix is projecting a Q4 contribution loss of around $65 million, which would imply a tiny $1 million improvement in quarterly losses for the second half of the year.

The Netherlands expansion is probably a major reason that Netflix's international profitability has not improved in the second half of 2013 after making rapid progress in the first half of the year. The underlying profitability of Netflix's international markets continues to improve, but every new market entry resets the bar lower.

The next round
While nothing's set in stone yet, Netflix may be eyeing some of the major continental European markets for its next round of international growth. Earlier this month, Netflix executives took a trip to Europe to meet with officials in France and Germany.

Furthermore, during the Netflix earnings interview in October, CEO Reed Hastings stated that the company was looking at expanding to some new large markets in 2014. Compared to Netflix's most recent new market, France and Germany definitely fit the bill. France is nearly four times larger than the Netherlands by population, and Germany is almost five times larger.

The larger size of these markets means Netflix will have to incur higher start-up costs to enter them. These start-up costs consist primarily of content spending that exceeds initial revenue (content costs tend to vary based on the size of the market covered) and advertising to build awareness (which will also be more expensive in larger markets).

If entering a small market like the Netherlands offset nearly two full quarters of international earnings improvement, entering just one of these larger markets could undo a whole year or more of improvement. The closest comparison may be Q1 2012, when Netflix entered the U.K. and Ireland and international losses widened by $43 million sequentially.

Foolish bottom line
Netflix should not automatically shy away from international expansion just because it will be expensive. Indeed, if the company can secure a first-mover position in Internet video within its new markets, they should become quite profitable over time.

But many investors appear to have unrealistic expectations of how profitable Netflix can be while it is still growing. Every time Netflix enters a new market, there is a noticeable decline in its international profitability. One of the major reasons that profit has grown so strongly in 2013 is that the company only entered one new international market, and a small one at that.

If Netflix enters France or Germany -- or both -- in 2014, its earnings will take a big step backward in the quarters following those market launches. Netflix investors need to be prepared for the fact that long-term growth may require significant short-term pain in the form of earnings declines.

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  • Report this Comment On December 13, 2013, at 6:53 PM, AceInMySleeve wrote:

    This is a fair article, particularly from a short biased author.

    "But many investors appear to have unrealistic expectations of how profitable Netflix can be while it is still growing"

    Here is where you are sneaking in the implication that losses from international expansion may lead to a decline in stock price because certain investors may be surprised by the magnitude of the loss.

    I tend to think this is an underestimation of the intelligence of the market. Those that are substantially surprised by what is an obvious fact (international is expensive) don't have a lot of pull.

    The market response to international should be related to actual data points that are hard to predict. i.e. we know it may cost 50M$+ for a new large market in a quarter, but we don't really know what kind of growth that may buy or how quickly a market may develop to profitability.

    Latin America appears to be a nightmare and likely the bulk of the losses. Canada was profitable quite quickly. I suspect the netherlands, scandinavia are hitting profitability on a reasonable but much slower schedule than Canada (~2 years). The UK is a very challenging market with a strong competitor who beat them to market (LoveFilm) and another very strong competitor with even better content that's priced higher (BSkyB). Nevertheless I think they've basically destroyed LoveFilm, and likely are running profits over there by now.

    Hastings recently implied that international could be 70% of their longterm revenue and that fits the estimates i had been making (that in 4 years they'd be at 50M domestic/100M international). I've been scratching my head at how slow they've recently been expanding, and thinking that 100m is unlikely in that timeframe, but there is time to accelerate and it should be exponential.

    There's 2 major themes that I think the market is beginning to credit but most stock commentators are missing which is that international really is a very large opportunity, and that the 8$ plan they have now, and the kinds of content that allows, is not necessarily what exists in 5,10,15 years. I think content will continue to shift from the traditional cable to streaming medium, and that they will continue to pay at least as much as they pay now. Potentially substantially more if advertising dollars switch to subscription dollars. This requires someone in the streaming domain to pick up and charge for this content. At the moment, the leader for that is Netflix but there's plenty of room. All content producers are going to want to monetize that content on every available platform, even if they are traditionally a cable network like AMC, FX, Fox, etc. This will also eventually be HBO. Streaming is a major expansion of the pie, people spend more time watching content, because of how it incorporates multiple viewing devices, and nonlinear programming.

    At any rate, I would be surprised if big money doesn't look at international from the reasonable perspective that it costs money to make money. Any and all details, Netflix is frustratingly sparse on these, that reflect on the ROI of that investment are what matters.

  • Report this Comment On December 13, 2013, at 7:32 PM, alboy5 wrote:

    This goof admits he wants Nflx to drop cause hes short.

    I love Nflx. Eurogeeks love Nflx. Klein's rant will be quickly forgotten.

    Nflx is way cheaper and better than cable.

  • Report this Comment On December 13, 2013, at 10:34 PM, TMFGemHunter wrote:

    @Ace: Thanks for your comments. I agree with a lot of what you said, although I think that the international opportunity will take a lot longer to materialize (100M international might be possible 15 years down the road, but I'd be shocked to see that kind of number much earlier). As it is, Netflix is running about breakeven on a FCF basis with a glacial pace of int'l expansion. An aggressive rollout that could hit 100M even by 2020 would require raising billions of dollars today to invest in startup costs.

    I want to clarify my point about investors not recognizing the cost of int'l expansion. Obviously, any reasonably sophisticated investor understands that it will cost money for Netflix to enter markets. The decision to enter/not enter should be based on the ROI, not the immediate impact on profit.

    However, the several-years out projections I have seen from bullish analysts imply pretty rapid int'l growth, but also significant margin expansion. In other words, they seem to be counting the revenue growth but not factoring in the initial hit to earnings. (Or maybe they think domestic earnings are going to expand even more quickly than my projections; I can't be sure.)

    In any case, I think Netflix could quite easily beat analysts' EPS targets for 2014 and 2015 (currently around $4 and $7, I think) by a bit... but only by foregoing international expansion. Once Netflix starts adding big countries like France and Germany, you're looking at maybe $250 million or more of losses in each market over a 2 year period before they reach breakeven. I don't see how Netflix can meet the current estimates if it moves to a faster int'l expansion pace.

    Hope that makes my position clearer.

    Adam

  • Report this Comment On December 15, 2013, at 10:00 AM, AceInMySleeve wrote:

    Netflix is up to 700m$ in total international losses. I suspect spending more time on it i could get some kind of model for what that means in terms of any particular market. But I'll grant 250m$ spread over 2 years (highest in first quarter of course) as sounding in the range of plausibility for a France->Germany size market.

    Netflix claimed at one point that q4 2012 would be the highest international loss so that's 105M. Assuming you hold them to that, one can work backwards to EPS by modelling the other segments.

    Personally not so interested in EPS in the moderately near term, but i'm sure others are. take care.

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