I Was (Half) Wrong About Netflix

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.

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Comments from our Foolish Readers

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  • Report this Comment On January 25, 2014, at 12:03 PM, AceInMySleeve wrote:

    Revenue increases exceed content cost increases.

    Since contracts are fixed price, the company that can take the most advantage of a particular bundle of content is the one that has the most subscribers. No one can monetize content as well as Netflix.

  • Report this Comment On January 25, 2014, at 12:32 PM, duuude1 wrote:

    Hey Adam,

    I echo Ace above - yes content costs are increasing fast as you say - BUT subs (rev) growth is even faster. AND mgmt can throttle content costs whenever they want to keep it at some % below subs growth, whatever that growth happens to be.

    Since mgmt has proven to be extremely accurate on next quarter's subs growth, they can peg their current content spend to match.

    So your partial retraction reminds me a little of Rocco the Pendulum Pendola's (partial) mea culpa. Rocco's pendulum had been stapled and super-glued to the bear since the beginning of time, but bear shook off the parasite and he's swung briefly to the other side. Rocco, however was quite obnoxious, as my recollection of all his previous articles were - you do a good job keeping a rational and objective tone to your (misguided :) ) articles.

    Stay safe on your short shares, duuude! It's only going to get worse... (I noticed one of Rocco's commenters regretting shorting NFLX based on Rocco's thesis).



  • Report this Comment On January 25, 2014, at 2:21 PM, TMFGemHunter wrote:

    I'll try to answer both comments together.

    Of course revenue increases are exceeding content cost increases. If they weren't, we'd be talking about whether NFLX is worth $50 or $150. In fact, I think it's likely that NFLX will grow EPS tenfold over the next 10 years, to the $20-$25 range. (In that sense I'm not bearish in the way that Rocco Pendola has been; he's thought the company would be insolvent in the next few years, while I just think it's massively overvalued.)

    I think Netflix's scale advantage in the U.S. would be a lot more significant but for the fact that it's biggest competitor is Amazon. Amazon has a completely different business model. First of all, I don't think it ever intends to make money on streaming video. It's more like a loss leader to bring in new Prime members, with the hope that they will then spend more with Amazon. If Netflix's goal is to be earning a $3 billion domestic contribution profit 10 years from now, Amazon could theoretically maintain an equivalent content library with tens of millions fewer subs.

    From a bigger-picture angle, it's not quite accurate to say that Netflix can peg content spending growth to subscriber growth. Netflix can certainly keep in mind projected subscriber growth when deciding how much content to license. But the effect goes both ways: the amount of content it buys will affect long-term subscriber numbers. If it cuts back too much, customers will eventually get frustrated.

    As a result, while Netflix can choose exactly how much it spends in a given quarter, it has to choose within a very small range if it wants to keep growing. And at some point within the next 5-10 years, it will fully saturate the U.S. market. Growing domestic revenue $250 million faster than domestic content/marketing costs -- as it did last year and I think it will do this year -- is not enough to justify even a $300 stock price.


  • Report this Comment On January 25, 2014, at 8:23 PM, AceInMySleeve wrote:

    Unfortunately we're left to puzzle over Amazon because we have almost no details other than Prime members pay nothing additional for streaming, there are around 20M of them, and streaming bandwidth is 5% of Netflix according to Sandvine.

    Now what I extrapolate from that is that Prime is a complete failure. You may extrapolate that Amazon is happy with the performance they get out of Prime customers. I don't see any good data provided to support that streaming leads to profitable upselling so it's based AFAICT on assuming that Bezos (and et al) isn't an idiot for continuing the streaming effort. Now I'll grant that I use the 'not an idiot' theory when I think about Netflix quite a bit so fine, I'll grant it, but very little to discuss at that point without data. How surprised would you be if they more or less gave up at some point this year? I wouldn't be.

    I would agree domestic streaming alone might not support 300, or at least that it's an optimistic price for that. But international should eventually get to half of ent value IMO (and much more than half in revenue). I'm hoping for 10 years of 15% returns out of this stock at this point, so I don't expect some fast run to 500 although I wouldn't sell if it did.

    btw, I am aware there is some bs statistic about how prime members spend more. I've never seen it expressed in a statistically valuable fashion.. i.e. Hospitals are some of the most dangeous places, half the people who go to one are injured!

  • Report this Comment On January 25, 2014, at 9:02 PM, duuude1 wrote:


    I've been puzzling over what AMZN will do with their streaming biz. Giving up the ghost is one option - but I don't think that's in Bezo's blood. Ramping up and going direct head-to-head against Reed is dumb, so I don't think he'll do that either. So I think he'll side step and play in a slightly different space - so one possibility I'll throw out is that AMZN will go head-to-head with Hulu instead and do ad-supported content. That way Bezos is getting revenues from the content, Prime customers still get "free video" (but with ads), and AMZN avoids direct competition with NFLX.


  • Report this Comment On January 26, 2014, at 1:05 PM, TMFGemHunter wrote:

    I'll be the first to admit that there's no data on how Prime is doing. However, I would be shocked if Amazon shuts down Prime Instant Video at any point in the next 5 years.

    My understanding of Amazon's strategy -- although it's just based on guesswork -- is that the goal is to grow Prime membership, usage, and sales, while keeping earnings at least breakeven or a tad better.

    Amazon is worth almost $200 billion now. That's a number that doesn't make sense based on what Amazon could be earning even 5 years from now. The only way the valuation makes sense is if you think the company will grow annual sales to well over $1 trillion over the next few decades.

    Wall Street and Jeff Bezos so far seem aligned in the idea that rapid sales growth is all that matters for the foreseeable future. Unless Wall Street falls out of love with Amazon stock, I don't think it's very likely that Amazon will do much trimming, even of underperforming businesses.

    On Prime Instant Video specifically, it's hard to know how to interpret that Sandvine data. First of all, Netflix is much more appealing to cord cutters than Amazon. As I mentioned in my article comparing Netflix and Prime, Amazon isn't that interested in winning those customers. So that subset of very high-usage subscribers is all going to Netflix. I also don't know if the average bit-rate is the same across different streaming services.

    For me personally, I really like Prime Instant Video, but I would guess that my fiance and I use it less than half an hour per day, on average. I think that compares to about 90 min. per day for an average Netflix user. I don't know if I am typical or atypical among Prime Instant Video users.


  • Report this Comment On January 27, 2014, at 2:55 PM, enneas wrote:

    Adam, thank you for the thought-provoking article. I think, however, that I agree with the first two commenters regarding content. As a user of NFLX, AMZN Prime, and HULU, I know first-hand that there's a lot of equivalency between the licensed content that the three offer (although NFLX dwarfs the other two). NFLX appears to intend to cross the hurdle you mention through original content. They have several new programs set for 2014, not to mention their content deal with Marvel, that I think will only further widen their moat. Unlike HBO et al, they already have a big platform and I think they intend to go deeper still into original content. That, to my mind, is how NFLX intends to avoid being boxed in by competitors as they fight for content licenses. I agree with you that the valuation and EPS haven't caught up yet but like an old soup commercial's tag line, "it's in there."

  • Report this Comment On January 27, 2014, at 4:04 PM, ZonaBob wrote:

    Listen-up, Netflix ‘bears’ –

    Who doesn’t want to ease back, shoes-off, feet up, in their living-room recliner, an adult beverage within easy-reaching-distance, while watching a movie in his/her own comfortable home? Can’t do THAT at a movie theater – if you can find one still in business in your ‘hood. And why wait days for a movie dvd to arrive via the US Mail? There are (I’ve counted them) at least ’24 physical movements’ required to play/return a DVD in this manner (mostly in your pajamas). And that’s just for ONE dvd. If you’re unaware, most people in the civilized world do this on a regular basis. Reed Hastings, CEO NFLX, brilliantly eliminated 22 of those physical movements (you still have to ‘reach’ for your remote). Not only that. With an ever-increasing cadre of over 40,000 movies, tv serials, documentaries …almost any entertainment venue… one can now watch almost anything, direct, from your recliner – and in ‘seconds’, not days. Talk about ‘instant gratification?’ I ask you again, who DOESN’T want that? Only about 30% of this planet’s inhabitants. Netflix is recently in Europe. Now, those good folks, our progenitors, know better than us how to relax. I spoke with a great friend in Amsterdam via e-mail recently to ask if they now have access to Netflix live-streaming: ‘Yes, Bob – and we are loving it!’ As Keanu Reeves said in the 1995 movie, ‘A Walk In the Clouds’ after the grape vineyards had been devastated by fire, “…look at the root!” There are another billion probable registrants out there on the global market for Netflix. Yes, Amazon is making a bid for market share. But, then, it doesn't have Reed Hastings – ‘the root.’

    …and you’re ‘short-selling’ your shares in this company?? As we used to say in the ‘70s, ‘Get your s__t together, people!!

  • Report this Comment On January 27, 2014, at 4:58 PM, pwolf wrote:

    Do you think Netflix should expand their reach by adding game rentals? What impact do you think it would have on their bottom line, either way?

  • Report this Comment On January 28, 2014, at 2:12 AM, ashleyjames389 wrote:

    Netflix has been very price elastic, price goes a bit high subscribers leave

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Adam Levine-Weinberg

Adam Levine-Weinberg is a senior Industrials/Consumer Goods specialist with The Motley Fool. He is an avid stock-market watcher and a value investor at heart. He primarily covers airline, auto, retail, and tech stocks. Follow him on Twitter for the latest news and commentary on the airline industry!

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