Streaming video leader Netflix, (NFLX -9.09%) reported strong Q4 earnings last week, bouncing back from a disappointing Q3 performance. Netflix exceeded its subscriber growth forecasts for both the domestic and (especially) international markets in Q4. This led to better than expected earnings, even before the impact of some one-time tax benefits.
Netflix reported better than expected earnings for Q4. Photo: The Motley Fool
Following the earnings report, Netflix's top 3 executives participated in a 45-minute interview with two Wall Street analysts to discuss the Q4 results. Here are five of the most important points that came up in that conversation.
Investing now, but profit is coming soon
I think in terms of profits earlier than expected, it's more that we have clear line of sight, in terms of rolling out the rest of our international expansion. We mentioned that we'd have a couple of years of heavy investment. I think that's going to drive capital needs ... -- Netflix CFO David Wells
In the company's Q4 investor letter, Netflix management stated that the company would complete its global rollout in the next two years while staying profitable. Netflix expects to earn "material global profits" thereafter. However, Netflix also announced plans to raise at least $1 billion of debt this year.
Analyst Mark Mahaney asked why Netflix needed more capital if it expected to stay profitable for the next two years and then become even more profitable thereafter. The answer is that Netflix is investing heavily in new original content.
Whereas Netflix pays for second-run content over the course of the license period, typically it must pay production costs up front for its originals. As a result, Netflix burned more than $100 million in cash in 2014, despite earning net income of $267 million. This gap between net income and free cash flow could widen in 2015, due to increased original content production.
Netflix is becoming a top destination for original content
On the original side, it's a very competitive market, and we are, fortunately, in a position ourself as a premier destination for the biggest and best projects. -- Netflix Chief Content Officer Ted Sarandos
Not that long ago, the idea of having a new show air on Netflix rather than a traditional broadcast or cable TV network was considered revolutionary -- or just plain strange. When Netflix first announced the Kevin Spacey drama House of Cards in March 2011, its decision to order two full seasons before seeing a pilot was seen as risky to the point of being reckless.
Netflix's bet on House of Cards was considered very risky back in 2011. Photo: The Motley Fool
Risky or not, House of Cards has been a solid success for Netflix. Moreover, it and a few other shows like Orange Is the New Black helped Netflix quickly gain credibility as a distributor of original content. As a result, Netflix now has excellent access to new show ideas that are being pitched. This improves its chances of finding future hits.
Original content is just one driver of growth
But when we're talking about our guide for Q1 at 1.8 million domestic members, in terms of growth, the addition of even House of Cards, Season Three is 100,000, 150,000... [O]n the margin it's helpful, but it's not the big thing that's going to drive the growth in Q1. -- David Wells
The success of its original content has been one important driving force behind Netflix's growth. However, original programming still makes up a relatively small part of Netflix's content library, and it's not the only thing driving growth.
Netflix CFO David Wells estimated that the launch of Season 3 of House of Cards next month will bring in about 100,000-150,000 incremental subscribers. That's a tangible return on Netflix's investment.
However, it's still a small fraction of Netflix's projected 1.8 million Q1 domestic subscriber additions. Clearly, Netflix is still benefiting from the growing acceptance of Internet video and is not wholly reliant on hit shows for subscriber growth.
ASPs will rise as Ultra HD grows
So I think what we'll be able to do is, as the high-end of the market spends $2,000 to get an Ultra HD television, it seems fair and natural to them... that there's a difference between HD and Ultra HD. That's a way that we get incremental revenue without making any changes ourselves, by just letting the tide come to us. -- Netflix CEO Reed Hastings
Netflix raised the price of its default package by $1 for new subscribers last year, while letting existing subscribers keep the old $7.99/month rate for two years. While Netflix is becoming more confident in its pricing power, the company still doesn't want to raise its prices every year, or even every other year.
Instead, it hopes to boost its average subscription price by convincing customers to upgrade to higher tiers. Most notably, in October, Netflix began requiring customers to have its $11.99/month package to stream Ultra HD content.
Netflix hopes to lure people to its $11.99/month price tier with Ultra HD content. Photo: The Motley Fool
Given the high cost of Ultra HD TVs, Netflix expects customers who buy them to pay a few extra dollars for Netflix to access 4K content. Over time, this trend should lift the average subscription price higher, independent of any broad-based price increases.
Latin America is finally maturing
We continue to see great growth and great potential in [Latin America]. It's a market with about 65 million broadband households. If you take that 5 million number that we talked about, and 65 million in terms of addressable, we think we've got a lot of room for growth in the market. -- David Wells
Not too long ago, Latin America was seen as a "problem market" for Netflix: An example of how international expansion could backfire. Netflix faced a variety of issues in Latin America such as poor broadband infrastructure and the lack of an established e-commerce payment system.
However, Netflix is gradually overcoming these constraints and adapting its business model to succeed in Latin America. The company passed the 5 million subscriber mark in Latin America last quarter, and sees a long runway for growth ahead, given the size of the market.
This also bodes well for Netflix's future prospects in other developing markets. Based on the company's new goal of completing its global rollout in the next two years, the lessons that Netflix learned in Latin America may soon be put to the test across the world.
