I Was (Half) Wrong About Netflix

A Netflix bear confesses.

Jan 25, 2014 at 11:45AM


In a series of articles here at The Motley Fool throughout 2013, I argued that Netflix (NASDAQ:NFLX) was rising too far, too fast. My "bearish" thesis had two main parts. First, I argued that Netflix was getting close to saturating the U.S. market, meaning that domestic subscriber growth was bound to slow down. I therefore found bulls' subscriber growth projections to be unrealistic.

Second, I believed that Netflix bulls were underestimating the growth of content costs. Whereas Icahn Enterprises (NASDAQ:IEP) portfolio managers David Schechter and Brett Icahn argued that Netflix's domestic content costs might rise by just $1 billion in the next five years, I expected a much bigger increase of around $2 billion in that time period.

The first part of my thesis was dead wrong. If Netflix were as close to saturating the domestic streaming market as I previously believed, subscriber growth would be slowing by now. Instead, the service added 2.33 million domestic streaming subscribers last quarter, the best result since Netflix began reporting the streaming business as a separate segment. Management also expects another strong performance this quarter, with about 2.25 million net domestic additions.

On the other hand, the evidence so far still supports the second part of my thesis. Content costs are growing faster than ever, and that will limit Netflix's ability to expand its profit margin for the next several years.

Subscriber growth stays strong
Not only was Netflix's Q4 subscriber growth stronger than what I expected, but it even exceeded Netflix executives' projections! Coming into the quarter, the midpoint of the company's guidance range called for 2.01 million net domestic streaming additions.

Netflix CEO Reed Hastings even insisted during the company's October earnings interview that this wasn't a conservative estimate, but reflected management's true expectations. (Of course, it's possible that he was fibbing!) In any case, the actual subscriber growth of 2.33 million in the domestic streaming segment nearly exceeded the high end of Netflix's guidance range.

Moreover, Netflix's Q1 guidance is surprisingly strong. At 2.25 million net domestic additions, it is already well above the Q1 2013 result of 2.03 million net additions. Moreover, Netflix's subscriber growth projections have tended to be conservative in recent quarters.

In any case, if my "saturation" thesis were true, Netflix should be showing signs of a slowdown in growth by now. It's true that Netflix significantly ramped up its domestic marketing spending last quarter to boost subscriber growth. Still, Netflix is projecting strong subscriber growth in Q1 even though marketing spending growth is likely to moderate.

This is noteworthy, because the Olympics will occur during the quarter, and Netflix called out the 2012 Olympics as a major factor dampening membership growth in Q3 of that year. In all, Netflix's continuing momentum in the U.S. suggests that saturation may not become a major factor until 2015 (or even later).

Cost growth unleashed
Entering 2014, Netflix's domestic subscriber growth trend is significantly better than I expected. However, the same cannot be said for cost growth. Netflix's efforts to add original content while gaining (or maintaining) exclusive rights to its most popular third-party content are inexorably driving content expense higher.

In Q4, "cost of revenues" in Netflix's domestic streaming segment -- a good proxy for domestic content costs -- rose $72 million, or 17.2%, year-over-year to more than $492 million. Based on the company's Q1 guidance, this growth in domestic content expense is likely to accelerate in the current quarter.

The difference between the domestic revenue estimate and the domestic contribution profit estimate represents an implied estimate of domestic contribution costs. For Q1, Netflix is projecting $598 million in contribution costs for the domestic streaming segment. This includes cost of revenues (i.e., content costs) and marketing expense. Since content expenses are mainly locked in through long-term agreements, this estimate should be fairly precise.

Assuming that marketing expense stays flat with last quarter's $74 million figure, domestic content costs will reach $524 million this quarter, up $32 million sequentially and up $87 million year over year. Even if quarterly domestic content costs stayed at $524 million through the rest of 2014, domestic content expense would be up nearly $250 million for the full year.

If we instead assume -- more realistically -- that content expense will increase by about $20 million in each of the remaining quarters, full-year domestic content expense would be up around 20% ($370 million).

Rapid growth in Netflix's global content liabilities provides further confirmation that content expense will remain on a steep upward trajectory for the foreseeable future. At the end of 2012, the company's total streaming content obligation was $5.6 billion. By the end of 2013, that figure had reached $7.3 billion, a 30% increase.

Foolish bottom line
Based on Netflix's membership growth during 2013 and its projections for yet another strong performance this quarter, it's clear that Netflix is not approaching saturation of the domestic market yet. As a result, Netflix's domestic subscriber totals are likely to outpace what I had previously expected over the next several years. In short, I was wrong to expect domestic subscriber growth to slow down soon.

However, the other part of my "bearish" thesis for Netflix -- rapid content cost growth -- is still supported by the available evidence. Domestic content expense alone is on pace to rise by $350 million to $400 million this year, offsetting more than half of the segment's likely revenue growth. As a result, I continue to believe that Netflix stock is overvalued, especially after its recent surge to nearly $400.

Profit from the death of cable!
You know cable's going away. But do you know how to profit from this sea change? Currently, cable grabs a big piece of the trillion dollar entertainment market. That won't last. And when cable falters, three companies are poised to benefit. Click here for their names. (Hint: They're not Netflix, Google, and Apple.)

Fool contributor Adam Levine-Weinberg owns shares of Apple, has options on Apple, and is short shares of Netflix. The Motley Fool recommends and owns shares of Apple, Google, and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't 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.

©1995-2014 The Motley Fool. All rights reserved. | Privacy/Legal Information