Netflix Inc. Bulls Are Still Underestimating Content Costs

After enduring a huge two-month slump in March and April, shares of Netflix, (NASDAQ: NFLX  ) have bounced back in a big way in the last five weeks. Netflix has rallied an incredible 40% from a bottom near $300 to around $420.

NFLX Chart

Netflix 3 Month Stock Chart, data by YCharts

There were two major pieces of Netflix "news" last month. First, the company raised its monthly price by $1 for new subscribers in the U.S. (and by a similar amount in other countries). Second, Netflix announced that it will expand to six new markets in Europe this fall. But both announcements had been long foreshadowed by Netflix management.

The rising optimism surrounding Netflix appears to be tied to impressive projections for its international growth. But these analyses seem to underestimate the corresponding rise in content costs that will occur. While global expansion will help Netflix grow revenue rapidly, it will also cause costs to rise nearly as quickly. As a result, profit growth may miss expectations.

Analysts' excitement
The excitement among Netflix bulls about international expansion can be seen in a recent analyst note from Oppenheimer & Co. The analysts upgraded Netflix stock to a buy rating with a $500 price target based on the expectation that Netflix could have 70 million international subscribers by 2020, up from 12.7 million at the end of last quarter.

Some analysts think Netflix could have 70 million international subscribers by 2020.

That figure seems a little ambitious to me, but it's certainly plausible depending on how quickly Netflix adds other new markets in future years. Analysts at other firms, including Robert W. Baird, agree that Netflix's international growth will really take off later this year. But growth alone does not guarantee big gains for Netflix investors.

Content costs are skyrocketing, too
As I have highlighted previously, Netflix's content costs have been rising quickly in the past few years -- albeit not quite as quickly as revenue has grown. In Netflix's domestic streaming segment, "cost of revenues" -- which primarily represents content costs -- rose by $290 million, or 19% last year.

Domestic content costs will continue rising rapidly for the next few years. Indeed, Netflix CEO Reed Hastings told investors during the April earnings interview that Netflix was raising prices primarily to pay for additional content and high-quality streaming capabilities. Even if content cost increases tail off toward the end of the decade, Netflix's domestic "cost of revenues" could approach $5 billion by 2020.

Outside the U.S., content costs are rising even faster. Last quarter, Netflix's international cost of goods sold was $245 million: up 47% year-over-year. Netflix had only added one relatively small international market since Q1 2013 (the Netherlands), so most of that increase came from higher content costs in existing markets. In Q2, Netflix will exceed a $1 billion annual run rate for international cost of goods sold.

Netflix's content costs have been rising rapidly.

This fall, Netflix is adding six international markets in Europe: Germany, Austria, Switzerland, France, Belgium, and Luxembourg. They have a combined population of about 175 million: more than that of all of Netflix's other international markets outside of Latin America.

This expansion will naturally accelerate the rise of Netflix's international content costs. Indeed, if Netflix's international market potential is ultimately 2-3 times the size of its domestic potential, investors should expect international content expenses to be 2-3 times higher than domestic content expenses in the long run.

International content expense is likely to exceed domestic content spending within three years or so. By 2020, international content costs could be $6 billion-$8 billion, again depending on the pace of Netflix's global expansion.

Foolish wrap
If Netflix manages to quintuple its international subscriber base to 60-70 million by 2020, it will be a very impressive accomplishment. But even with that rate of subscriber growth, profits may be very thin.

The issue is simply that content costs are already growing rapidly, and expanding into lots of new markets will drive these costs even higher. Broadening the scope of Netflix will lead to user growth and revenue growth, but not much earnings growth. Earnings growth comes from fully penetrating each individual market and leveraging content costs.

Netflix has done this successfully in the U.S., but it doesn't have the same massive head start or the same level of brand recognition in its new international markets. Netflix will need to replicate its dominance of subscription video-on-demand in each new market to grow earnings fast enough to meet bulls' hopes. Whether or not this will happen is still very much an open question.

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  • Report this Comment On June 04, 2014, at 12:39 PM, ckgod wrote:

    So are you saying selling more cars is not good for GM or Toyota and having more customers is not good for McDonalds, Amazon or Walmart...because costs will go up too? What a piece of garbage.

  • Report this Comment On June 04, 2014, at 1:55 PM, cerebron wrote:

    Does it bother anyone that NFLX management owns less than 2% of the total outstanding shares of stock? Where is their confidence and motivation?

  • Report this Comment On June 04, 2014, at 2:56 PM, AceInMySleeve wrote:

    I think you were mailing this one in.

  • Report this Comment On June 04, 2014, at 4:19 PM, 24penny wrote:

    It bothers me. They seem to exercise their options as soon as they vest. And isn't true that the only shares Hastings owns are in a family trust?

    They may have confidence in the company but certainly not in the current share price.

  • Report this Comment On June 05, 2014, at 10:15 AM, TMFGemHunter wrote:

    @ckgod: Actually, it's quite similar. It's great for all those companies to get more customers in the same markets. However, building more stores, warehouses, factories, etc. in far flung parts of the world doesn't necessarily make sense because while you will get more customers, the new markets won't necessarily be profitable.

    @cerebron: Yes, it's unfortunate, but it's also very common. I don't think you can read too much into it.

    Adam

  • Report this Comment On June 05, 2014, at 3:40 PM, JudasTouch wrote:

    One point that might be getting overlooked here: Netflix has absolute control over its content spending, and it has long stood by its mantra that it will not overpay for content. Starz learned that content owners can price themselves out of Netflix's market; but, importantly, not getting Starz's content didn't mean that Netflix had a big hole in its offerings--it just wrote a big check to a different content owner.

    Netflix's content costs are high now because it is making hay while the sun is shining, getting into as many markets as possible as quickly as prudence allows. This is the time for Netflix leadership to invest heavily in growing the business. As they get closer to full market penetration, they will be able to dial back the spending in order to maintain profitability.

    One might worry that Netflix could end up a victim of its own success by bidding up the price of good content. What if all the content owners want more than Netflix is willing to pay? That's a good question, but I will only be concerned if there's an outfit that is consistently willing to pay more than Netflix does for content. Right now, Amazon seems the biggest contender, but they have a lot of other operations to fund, and they're using streaming as a loss-leader. Netflix does one thing, and they do it very, very well, at a profit level they get to pick, to boot.

    Every content owner wants the most money for their rights. If their choice is "Netflix for $10M or Amazon for $11M," of course they'll go with Amazon. If Amazon (or any company) can outbid Netflix for years, the Netflix is in trouble. But I think that the choice will mostly be "Netflix for $10M or nothing." It's not as good as the $11M they wanted, but it's better than a fistful of nothing.

  • Report this Comment On June 05, 2014, at 9:24 PM, TMFGemHunter wrote:

    @JudasTouch: I think you raise a good point. My concern is that while Netflix says it won't overpay, everything is relative. If you look at cable operators, which are not adding content and operate in a totally mature (arguably declining) market, their content costs are rising at a high single digit rate. I doubt that Netflix can do better at combating content cost inflation.

    Right now, on the domestic side, Netflix's revenue is growing fast enough that it can absorb 18%-20% annual increases in content spending. 5 years from now, Netflix's domestic subscriber growth will be single digits. What then? I don't think Netflix will be able to maintain the quality of its content library in the long run if it's only willing to increase spending by 3%-4% annually. That means either giving up margin or following the pay-TV industry with annual price increases.

    Adam

  • Report this Comment On June 05, 2014, at 11:18 PM, JudasTouch wrote:

    Adam,

    Fair point on the cable operators' rising costs and the related...er, relativity. One wonders, though, how much of that cost increase is due to Netflix's deep pockets being in play. That is to say, I think Netflix is the biggest driver of content cost inflation. It goes back to my last paragraph. Netflix is the company that's driving up content prices for everyone right now, and they will continue to do so until they feel comfortable with their global market position (an approach I approve of). It's a plank of my thesis that, once they stop spending so heavily on content, the growth in content prices will slow down, because there won't be anyone else willing to consistently spend so much on content. One hole in my thesis is that it relies on nobody being able (or willing) to outspend Netflix on content over an extended period (I'm thinking several years). I think the biggest threats on that front (Apple, Amazon...maybe Google, but I doubt it) are "distracted" (for lack of a better term) by more important, higher margin businesses, whereas Netflix has the luxury of laser-like focus.

    Plus, if "House of Cards" is any indication, Netflix appears poised to become a "boutique" label. If they can attract A-list talent with a promise of complete artistic freedom, that's quite a draw. It is not, however, much of a moat, which is another reason why I think Netflix needs to spend like crazy right now: to attract as much industry love and as many viewers as possible early on.

    It's certainly entertaining to watch it play out.

    Mike

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