Will Netflix, Inc.'s European Expansion Be a Big Hit for Investors?

Netflix, Inc. is about to embark on a big expansion in Europe. Is this a good move from an investor standpoint?

Sep 3, 2014 at 7:30PM

The calendar has turned to September, and that means that Netflix (NASDAQ:NFLX) is about to embark on one of the biggest international expansion projects ever. Later this month, Netflix service will become available in France, Germany, Austria, Switzerland, Belgium, and Luxembourg.

Netflix is already growing rapidly. Last quarter, revenue rose 25% year-over-year. Expanding into 6 more markets (including 2 large ones in France and Germany) will keep revenue rising quickly. However, strong revenue growth does not guarantee stock price appreciation.

Consumer Goods Streaming Media Netflix Nflx Loading Screen

Netflix will add 6 new markets in Europe later this week (Photo: The Motley Fool)

Netflix trades at a very high valuation: more than 100 times expected 2014 earnings. Costs are also rising nearly as quickly as revenue is growing -- and international expansion will be expensive. Just how successful must the European expansion be for Netflix shares to keep moving higher? Read on to find out.

Bringing Netflix to more of Europe
Today, the Netflix streaming service is available in a handful of European countries: the U.K., Ireland, Denmark, Norway, Sweden, Finland, and the Netherlands. Those 7 countries have 35 million-40 million broadband households who might potentially subscribe to Netflix.

Netflix's upcoming expansion will nearly triple its addressable market in Europe, as its 6 new markets have more than 60 million broadband households, according to Netflix. This will bring its total international addressable market to roughly 180 million households: twice the size of the domestic market.

Expansion will be costly
International expansion is a long-term play for Netflix. The company began expanding beyond the U.S. nearly 4 years ago, and its international operations have posted cumulative losses of more than $800 million since then.

Netflix's international segment has yet to generate a contribution profit in any quarter. It would have been on track to reach breakeven in Q3 (or at worst, Q4) of 2014. However, the looming expansion in Europe will be dilutive to earnings. For Q3, Netflix has projected that its international contribution loss will widen sequentially from $15 million to $42 million.

Consumer Goods Streaming Media Netflix Nflx Content

Netflix needs to invest heavily in content when it enters a new market (Photo: The Motley Fool)

Indeed, Netflix's track record in international markets shows that it takes 2-3 years for a typical market to reach breakeven. The long ramp-up to profitability is inherent in Netflix's business model. Whereas cable TV companies pay for content on a per-customer basis, Netflix generally pays a flat fee that does not vary based on subscriber totals.

When Netflix launches in a new market, it must first invest in content deals in order to attract potential new customers. It also needs to spend money on advertising in order to build consumer awareness. Yet it starts with no subscribers (and thus no revenue). This leads to significant initial losses in new markets.

Quantifying the cost of expansion
The near term cost of expanding in Europe will be significantly higher than the $27 million projected increase in Netflix's international contribution loss this quarter. Netflix will not launch its new markets until later in September, so it will only be paying a small portion of its quarterly content bill.

The company also tends to ramp up its marketing spending after it launches its new markets. Lastly, Netflix increases its content spending significantly in the years following a new market launch, according to CFO David Wells. These 3 factors mean that international contribution losses will spike higher again in Q4.

The closest parallel to the upcoming European expansion was Netflix's January 2012 entry into the U.K and Ireland. Launch-related costs drove a $43 million sequential increase in Netflix's international contribution loss in Q1 2012.

The new markets launching this month have nearly 3 times as many broadband households as the U.K. and Ireland. As a result, the initial quarterly contribution loss from these new territories could be almost 3 times the size of the $43 million hit from the U.K. and Ireland launch: perhaps $100 million-$120 million.

Offsetting this, all of Netflix's other international markets have been steadily reducing their contribution losses each quarter. Netflix's international contribution loss is still likely to rise substantially beyond $42 million in Q4, and could go as high as $100 million.

The long-term potential for European expansion
Nobody really knows how profitable international markets can be in the long run, as none of Netflix's markets have yet reached maturity. Domestic profitability trends may be the best proxy for future international profitability. That said, some of Netflix's new markets may be harder to penetrate than the U.S. market, due to higher competition and/or lower interest in Hollywood content.

Netflix launched streaming video in the U.S. in early 2007. In late 2010 (about 4 years ago), Netflix began treating streaming as its primary offering, not just as an add-on to DVD rental plans. By the end of that year, Netflix already had about 20 million U.S. subscribers: a testament to its having built a strong brand in the U.S. during the previous decade.

Consumer Goods Streaming Media Netflix Nflx Amazon Amzn Hulu

Netflix dominates U.S. streaming thanks to its first-mover position (Photo: The Motley Fool)

Based on this strong starting position, Netflix expects to surpass a 30% domestic contribution margin next year. Nearly half of all U.S. broadband households (or approximately 45 million households) will subscribe to Netflix, enabling that strong margin result. Beyond that, management is still evaluating how far margins could expand.

Netflix's new international markets could potentially reach a 30% contribution margin one day -- but that day is far away. In the U.S., Netflix has been increasing its market penetration by about 7 percentage points per year recently.

At that rate, it would take 7 years for Netflix to reach 50% penetration of a new market. That appears to be the approximate level necessary to produce a 30% contribution margin -- at least based on Netflix's current business model.

However, if a 30% contribution margin is ultimately attainable, Netflix can afford to be patient. Based on the size of Netflix's new European markets (more than 60 million broadband households), reaching a 50% penetration rate and 30% contribution margin would result in an annual profit stream of more than $1 billion. That would fully justify the start-up costs, which will almost certainly be less than $1 billion.

Foolish final thoughts
If Netflix can be anywhere near as successful in its new European markets as it has been in the U.S., its international expansion will be a good thing for long-term investors. Netflix believes it can ultimately convert two-thirds or more of U.S. households to Netflix subscribers -- but even with 50% penetration (or a little less), it can earn strong margins.

The risk for investors is if Netflix is significantly less popular in its new markets. There are fewer English speakers than in its current European markets, which could force Netflix to rely more on local content than on Hollywood content (its specialty).

Additionally, competitors have had more time to react in Netflix's new markets, whereas Netflix had a stranglehold on the U.S. and Canadian markets before other media companies realized that streaming video could be a huge business.

Despite these obstacles, Netflix has a good shot to be very successful in continental Europe. If Netflix can increase its market penetration there by at least 5 percentage points per year in the next few years, investors can be satisfied that those markets will ultimately produce big profits.

Adam Levine-Weinberg is short shares of Netflix. The Motley Fool recommends Netflix. The Motley Fool owns shares of 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.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.

Compare Brokers