Where Does Netflix Go from Here?

Netlfix continues to be an attractive investment, as the company's huge investments in original content continues to increase its subscriber base at an admirable pace, especially its international market segment.

Jan 8, 2014 at 3:55PM

Netflix (NASDAQ:NFLX) had a stellar 2013. It posted blowout financial results during the year, while its shares soared around 300% riding on the back of robust growth in its streaming subscriber base. Meanwhile, Netflix's investment in original content seems to be paying off.

The video streaming company is also reportedly in talks with the country's largest cable company, Comcast (NASDAQ:CMCSA), seeking to partner with the cable giant in a bid to bolster its distribution and marketing capabilities. After a huge run-up, can the company keep up with its wild growth?

First off, Netflix will have a hard time maintaining the blistering pace in its subscriber base that it's enjoyed the past few years. Amazon.com (NASDAQ:AMZN) with its Amazon Prime subscriber base of 15 million, as well as Hulu, will be hot on its heels. Still, Netflix should continue to be the industry leader in video streaming for the foreseeable future. Netflix will also continue to spend tons of cash on original content, and move to stabilize its overseas business.

Growth for domestic streaming subscribers to slacken
Netflix has a long-term growth target to incrementally expand its domestic streaming contribution margin by around 400 basis points each year. Now, that's really ambitious, even for Netflix. The company will need to sustain its domestic subscriber additions by 6 million each year to pull that off.

That kind of growth looks like a long-shot when you consider that Netflix has already covered close to a third of U.S. households. With increasing penetration, Netflix will find it increasingly hard to keep up that growth rate.

When you look at the company's recent growth in its domestic subscriber base, there is a deceleration in pace. The growth rate stood at 25.6% in the fourth quarter of 2012, but had tapered off to 23.9% in the third quarter of 2013. Netflix will most likely become a victim of its own success here; the company has grown so fast and so extensively that it would require an almost unimaginable level of content investment to continue growing at these rates.

With the company's content obligations having increased dramatically over the past few years (badly impinging on its cash flow and operating margins), Netflix will simply have to settle for considerably lower growth rates for its domestic subscribers in the long-term. That means its current growth rate will slow. 

Jump in international profitability
As Netflix's international subscriber base continues to grow, the company's contribution loss is likely to come down substantially as its costs are spread out over a wider revenue base. Subscriber growth in Canada, Europe, and Latin America was 114% in 2013 compared to 2012, bringing the number to around 7.75 million subscribers in the second quarter. The international contribution loss averaged $97.29 million per quarter in 2012, but came down to $72.35 million per quarter for the first three quarters of 2013. This encouraging trend is likely to continue as more subscribers sign up with the video streaming giant.

Latin America in particular has a huge addressable market, with more than 50 million households with access to broadband. Even at a modest 30% annual growth rate, Netflix can potentially grow its international subscriber base to around 50 million in seven years. The company has inked partnerships with cable and pay-TV companies such as Virgin Media and Com Hem in a bid to accelerate growth in its international subscriber base.

More original content
One common rap against Netflix is its ever growing cost of original content, which seems to have ballooned out of control. The firm's content costs have risen dramatically over the years in its efforts to expand its streaming library both domestically and internationally.

In 2011 one of Netflix's content partners, Starz, was demanding an incredible ten-fold increase for the content it supplies to Netflix. This would have seen the firm's original $30 million deal jump to $300 million. This is a prime example of how much streaming content costs have been skyrocketing as competitors bid up their prices, and media companies realize the full value of their content.

Netflix's streaming content obligations show no signs of slowing down. The figure stood at $4.97 billion by the end of third-quarter 2012, but grew to $6.5 billion in the third-quarter of 2013, a huge 38.3% annual increase. This is certainly a worrying trend, but unfortunately it's the price Netflix has to pay if it hopes to continue growing its subscriber base in the face of stiff competition from the likes of Hulu and Amazon Prime.

Despite Netflix's swelling cost of content, expect it to continue investing heavily in original content. Netflix has been busy adding original and exclusive programming to its library, and this seems to be paying off handsomely.

Netflix signed several deals in 2013 with content providers. These will enable the company to continue bringing more exclusive TV shows in 2014. TV series such as Hemlock Grove, Lilyhammer, House of Cards, and Orange is the New Black drew in large audiences and attracted many new customers in 2013.

Foolish bottom line
Netflix operates a subscription/recurring revenue model that makes it more predictable than many Internet companies. Its revenue growth in 2013 came in at a respectable 15% to 20%. The company's growing cost of original content is a necessary evil that its investors have to endure as Netflix continues to grow both its domestic and international markets.

Despite the stratospheric valuation, Netflix strong subscriber growth should offer further valuation support, and help its shares hold steady in the near-term and improve in the long-term.

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Fool contributor Joseph Gacinga has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and Netflix. The Motley Fool owns shares of Amazon.com and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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