Netflix Is Far From Done

Last week, shares of Netflix (NFLX 4.17%) rallied after the company announced plans to increase prices for most of its streaming packages. In this episode of Industry Focus: Tech, analyst Dylan Lewis and contributor Danny Vena break down the pricing changes, and explain why the market is reacting so positively to them. Then, they dive into Netflix's presence in international markets.

Listen in to find out how Netflix is doing so well in markets around the world; why the company has failed to crack into the Chinese market just yet, and how they might break into it in the future; what the recent price increases will mean for Netflix's bottom line in the next few quarters; and more.

A full transcript follows the video.

This video was recorded on Oct. 13, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, Oct. 13. We're talking price hikes and growth drivers for Netflix ahead of the company's earnings report next week. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com's Danny Vena. Danny, how's it going?

Danny Vena: It's going good! How are things in sunny Alexandria?

Lewis: Doing all right. It is Friday the 13th for this show. Do you have any interesting or unique superstitions? I know it's a date that makes some people a little queasy.

Vena: Most of my thoughts around superstitions are, some of them are based in common sense, and some of them make no sense.

Lewis: Can you give me one that makes no sense?

Vena: Black cats is an example. That doesn't make any sense to me. I'm sure if ties back to witches and black cats and that kind of thing. However, you don't necessarily want to go walking under a ladder for common-sense reasons.

Lewis: Sometimes it's better to just not tempt fate, right?

Vena: Right.

Lewis: Today, we're going to be talking about a company that doesn't seem to have any issues right now, no superstitions. Hopefully Friday the 13th won't change that in any way. Netflix. They have been on an absolute tear lately. They're near all-time highs, they got some interesting news coming out that the market was very happy about with their price hikes. We have a lot to talk about ahead of their earnings report next week, Danny.

Vena: A lot. It's always good news, though.

Lewis: Always good news. Why don't we first start talking about what's going on with the price hikes? Like I said, the market was very happy to see this news. And for them, it's a really easy lever to pull to boost revenue, so I think that's probably why we saw this positive reaction. Why don't we run through what people will be expecting with their next couple of billing cycles?

Vena: I think Netflix has already rolled out, on their website, the new prices. So, for new customers, those prices are already going to start immediately. For existing customers, for those that have the lowest plan, $7.99 for one stream, that will not change. The most popular plan, which is the concurrent, two-streams plan with the HD option, that's the most popular one, that will be going from $9.99 to $10.99, so up $1. And the higher-option plan, the one that has HD, ultra HD, four concurrent streams, the price of that plan will be going from $11.99 to $13.99.

Lewis: So, we're seeing an increase for most subscribers of either $1 or $2 a month. For folks who are already using the service, I believe this is something that might start hitting existing subscribers mid- to late October, but they'll really be rolling out the increases over the next couple of months, and I think they're going to be giving all their customers about 30 days' notice ahead of being hit with anything on the billing side, right?

Vena: That's my understanding. They're supposed to roll out, the notifications should go out to customers sometime in the next week or two, and then it will give them 30 days from their next billing cycle to make a decision. Frankly, for $1, I don't think many people are going to care.

Lewis: And I think that's kind of what the company is banking on. You look at what they're offering people, the fact that it's the primary media consumption location for a lot of people, and only paying $11 or $13 a month, it doesn't really seem like that much, given how many hours people spend streaming content on the service.

Vena: Exactly. If you look at your average cable bill, the lower ones run $70 a month, the higher ones can run over $100. There's definitely a lot of benefit to a $10.99-$13.99 plan.

Lewis: So, this doesn't seem like the kind of thing that will really meaningfully irritate consumers. You might lose a couple of people here and there. But it seems like something that investors are really cheering, and I think the reason for that is, you look at the company's average revenue per user over the last couple of years, and that has steadily climbed both in the domestic market and the international streaming market. You go back to Q2 of 2017, their most recently reported quarter, was $10 ARPU in the U.S., just under $8 internationally, and those numbers are based on paid subscribers, not total subscribers. It seems like kind of a false number if you base it off of folks who are also enjoying the free trial. You go back a year prior, it was $8.80 in the United States and $7.46 internationally. So, they're showing nice growth there. Then, think about the fact that the average prices that most of these people are going to be paying is probably going up at least $1-$2. That's probably going to steadily climb in the coming quarters and over the course of the next year.

Vena: I think that's true. Trying to get an idea of how that's going to affect their top and bottom line, we got a little help from RBC Capital's Mark Mahaney. He estimates that this increase will create incremental revenue of about $650 million for fiscal 2018, and an additional contribution margin of about $274 million.

Lewis: And I put together some numbers myself before the show, just ballparking what this might look like. If you take their most recent quarter, and say, we're going to assume average revenue per user goes up by $1 domestically, that's going to be an extra $600 million, roughly, that they're going to be pulling in, which is basically a 10% lift in revenue without any user growth. So, think about the levers that they have here, for them to increase their revenue, it's either going to become something where they add more people to their services, more end users on those services, or they're charging people more for using the services. Unless we see some crazy exodus because they're charging $1 or $2 more, I think this pricing move is a great move. And also it might show that there's room even higher for them to continue to expand prices in the future.

Vena: I'm a Netflix customer, and for full disclosure I should say that I'm a Netflix bull. I bought my first Netflix stock back in 2007, and have ridden it the entire way without selling. So, staunch believer in the model that they use. It represents about 15% of my portfolio right now, having grown there.

Lewis: A lot of people would kill to have that cost basis, Danny. [laughs] 

Vena: [laughs] You know, it's one of those, every investor makes one really good decision. The old saying goes, even a blind squirrel will occasionally find a nut. This is mine.

Lewis: [laughs] So, we ran through what this might look like for them down the road. When Netflix reports in this most recent quarter next week, those price hikes will not be reflected in the numbers. That will figure into the equation once we get into calendar Q4 and beyond. But why don't we look at this upcoming quarter? They're going to be reporting next week. What should people be looking for? I know last time they reported, you put together this great article honing in on six specific metrics that really showed how they blew the doors off the quarter. What are you looking at this quarter? What are you watching?

Vena: Pretty much like everybody else that follows the company, one of the things I'll be watching for is subscriber growth. It's worth noting that Netflix has been very accurate when it comes to forecasting subscriber growth. You can go all the way back a decade, and if my memory serves, I think they've come in on the low side probably half a dozen times in more than a decade.

Lewis: That's a pretty impressive track record.

Vena: I'd love to have a track record like that.

Lewis: [laughs] I think we all would. So, what are they looking at for this upcoming quarter?

Vena: For the quarter that's coming up now, they forecast an overall increase of about 4% subscriber growth, which will be divided up about 750,000 new subscribers domestically, and about 3.65 million new international subscribers. So, they're looking at their overall subscriber growth to grow from just under 104 million to just over 108 million.

Lewis: And we talked about the different elements of that revenue number for them. With prices increasing and then continuing to draw in new users, that should bode pretty well for the top line, right?

Vena: Absolutely. Right now, they forecasted their revenue would increase approximately 30% year over year. The prior quarter, up to $2.969 billion. So, just under $3 billion in revenue for the quarter. And they're also looking for earnings per share to more than triple from $0.12 a share to $0.32 per share. Sorry -- just less than triple.

Lewis: So, we're seeing a consistently profitable Netflix, which is a little surprising for a lot of people.

Vena: A lot of people, when they look at Netflix, they confuse the cash flow situation with the earnings situation. Netflix has been spending an extremely high amount of cash. They're going to spend $6 billion this year on content. But a lot of that money is borrowed, and it has to be paid back over time, so it's not really affecting their earnings potential right now. It will gradually, over time. But, again, if you take that content cost and stretch it out over four or five years, the time that they will earn subscribers over that content, it's a lot different than the cash flow, because they're putting out money upfront to create this new content.

Lewis: One thing I want to go back to briefly with the point you made earlier was looking at what the net adds for subscribers will look like. Looking at that 750,000 domestic and 3.6 million international, I think we're going to see the continuation of a trend that really first got on our radar last quarter, where international becomes the majority of users for Netflix. For a long time, that wasn't the case, and they finally broke through that recently.

Vena: That's exactly right. In fact, this will be the first quarter where paid international subscribers should exceed paid domestic subscribers. As you mentioned earlier, Netflix gives out a 30-day free trial to pretty much anybody who wants it. They get the free trial, and many of them keep the service. So, there's always those non-paid subscribers in the mix. But for this quarter, they're expecting paid international subscribers to exceed 52 million subscribers versus 51 million for domestic.

Lewis: Which is what you want to see long-term, because we're noticing, there seems to be some market saturation happening in the United States. This is something we're going to touch on in the second half of the show. For this company to really live up to the growth expectations currently priced into it, they're going to have to become staples of content for all these foreign markets, right?

Vena: That's exactly right. They're going to top out in the U.S. market at some point. The growth will probably continue to slow, but I don't think it will stop. Netflix believes that they can have probably 60% penetration in the U.S. And, if memory serves, I think we're somewhere just north of 50% penetration, right now. So, there is still a little bit more growth to be had, here, but the big growth is going to happen internationally.

Lewis: Danny, we teased up that Netflix has really never looked cheap on a standard valuation basis. But even with this point that we're getting to, where the U.S. market is becoming increasingly saturated -- we talked about how they're at 50% penetration, maybe that ceiling is somewhere in the 60% range -- we're still looking at a company with a P/E over 200, and a price-to-sales of over 8 on a trailing basis. So, there are some big, big growth expectations still built into this stock. For them to really live up to that, the international markets are going to have to come through for them, right?

Vena: Absolutely. The old saying goes that past performance is no guarantee of future results, so we'll get that out of the way right at the front. But, I think if you look back at some of Netflix's more mature international markets, we can use that as a guide to see how they will progress in the rest of the world. And one of the company's more mature international markets is Brazil. If you look at how the company has done in Brazil, what we're looking at, we're going back to a survey that was conducted by RBC Capital, Mark Mahaney, in his survey he found a record-high 77% of surveyed Brazilians watch Netflix, up from 71% the year before. 77%.

Lewis: You think about that timeline we're talking about here, this is a recent note. The company really first got into that market in 2011. So, this is something that's taken five years to get to this point. And you look back at their decision to really massively expand, I believe that was in 2016 that they made the announcement that they were effectively going into 190 countries, that might give you this immediate shockwave-type growth expectation. But the reality is, this is something that takes several years to build out, even though it's a very scalable tech platform.

Vena: That's true. A lot of what happens is, Netflix will invest in some content, they'll get into the market, and then they'll learn about their customer base there. And what works in Brazil may not work in Germany, may not work in France. So, they cater to those local markets. Those local geographies end up getting a much different experience, just depending on what their customers want.

Lewis: And really, for them to have a lasting effect and establish a big footprint in these markets, localized content plays a role. You can only port over so many English-speaking titles to foreign countries and have it be translated before people decide, "OK, we want content that's also made for us, or that's designed to be in our language and is acted out that way." So, those type of content investments the company is making, that's part of that growth ramp that we see over the couple of years.

Vena: That's true. I remember listening to Reed Hastings, Netflix CEO, talking at an industry conference or something, I don't remember exactly what it was. But, he pointed out a program called "3%." The program "3%" was one that they did specifically for the Brazilian market. But, what they found was, not only did it do really well in Brazil, but there were pockets all over the world that really liked that show. That show did well in the United States, it did well in Germany, it did well in several other geographies. So, I think that's one of the things that's going to serve them well going forward. Sure, they cater some of these programs to the local markets, but really quality programming is going to translate across the globe.

Lewis: And you look at the way that platform is built, you have video content, which we've seen over decades as very strong to consumers -- you look at the strength of the cable business for such a long time, and how appealing that is. And then, you also have this data analytics platform that shows exactly what people are watching, how much of it they're watching, in all these local geographies. Having all of that underlying data is huge for them in making content decisions, and understanding what they need to promote in some of these local markets to increase the use case and the value that their service is providing for people in those markets.

Vena: One of the ways that shows is when you look at the customer satisfaction ratings. For instance, in Brazil, 90% of the users in Brazil were either extremely satisfied or very satisfied with the service, and 66% of them said they were not at all likely to cancel the service. So, that's an extremely high level of customer satisfaction.

Lewis: And that's one of the things that has made their free trial so compelling to people. You think about the number of businesses that give something away and don't wind up retaining customers. That's actually one of the big issues with recent IPO Blue Apron, they have these very high customer acquisition costs because they give away meal kits to get people to try the service. The problem is, it's very easy for someone to do that for a couple of weeks and then decide they're not interested. But, by giving people a lens into what's behind that trial wall, and get to try out all their Netflix originals, be able to watch some of their favorite shows like The Office or How I Met Your Mother or something like that on demand, that becomes something you get very used to very quickly, particularly for the content you can only get at Netflix, it makes it pretty easy to fork over $10 or $12 or $14 a month for access to all that content.

Vena: That's true. One of the things that I find that's really compelling about this story, we keep going back to Brazil, but Brazil is a country, if you go back and look over the last five or six years, the country has been embroiled in political instability, there's been scandal after scandal, there's been bribery accusations against high government officials, there's been high levels of inflation, they've been in a recession for the last two years. And yet, with all that going on, Netflix has been experiencing explosive growth in the area. So, I think the value proposition is there. Even if people can't afford a lot of luxuries, they can afford $10 or $11 a month for streaming Netflix.

Lewis: Yeah. They're coming in at a great price point, even in a market like Brazil that's experiencing some issues. One market where I think we have these huge expectations as investors and consumers for a lot of multinationals, where Netflix is frankly not going to see massive growth, is China. And that's because, they've tried to crack this nut for a while, and they're kind of there now, but not really in the same way that they're in all the other countries. Right, Danny?

Vena: You're exactly right, Dylan. A little bit of background on China to help set this up: China has very strict rules regarding imported material. And that extends to content, as well. And when Netflix was trying to break into the Chinese market, one of the things they were up against was a government regulation that said no service could have more than 30% of foreign content. So, that's going to be all content in the United States and every other country. So, there was a very small area for them to break into. So, what Netflix did was partner with Baidu (BIDU 1.02%). Baidu is the online search engine of choice in China. Baidu has a service called iQiyi. iQiyi is widely considered to be the Netflix of China. So, they partnered with iQiyi, with Baidu, and you can see some Netflix originals on iQiyi's streaming service in China.

Lewis: But, with the nature of that contract, and it being more of a licensing deal than them being able to pull in these recurring subscription revenue figures every quarter, every month, that's going to change the way they're able to make money. It caps what things might actually look like for Netflix in China, at least for the foreseeable future.

Vena: Right. It completely changes the dynamic of how they make money there. And you're right, they're not going to be able to get the recurring revenue stream from the subscriber base. What they'll do is, they'll negotiate with Baidu and iQiyi. I recently found out that sometimes it takes up to a year for content to be approved. Once it's submitted to the government, it has to be approved before it can go on the air, and sometimes those approvals can take more than a year.

Lewis: Yeah. So, don't expect anything too big out of China, at least for Netflix's results specifically. If you're interested in seeing what's going on with the streaming space in China, there are some recent developments with Baidu and iQiyi that might give us a little more insight into what's going on in that market.

Vena: One of the news stories that hit recently was, Baidu is considering an IPO for its streaming service iQiyi, valuing that company at somewhere between $8 [billion]-$10 billion. There's been some controversy around that before. Robin Li, who is the CEO of Baidu, last year tried to spin that off and actually buy it and take it private. There was a little bit of a shareholder uproar over that. They abandoned that plan. So now, they're trying to spin it out as a public company. What they were planning on doing was maintaining more than 50% control of it and spinning off the remainder. But, we do have some research out there that gives us a little insight into the market in China. Streaming video is extremely popular in China, with an estimated 144 million subscribers that will tune in this year, and that's an 80% increase over last year.

Lewis: I think, for context, think about that, was it 50 million subscribers that Netflix has in the United States right now. That's a massively larger market at the moment.

Vena: And iQiyi, according to some estimates from JPMorgan that we got via eMarketer, they forecast that this year, iQiyi will have 99 million subscribers -- effectively twice what Netflix has in the domestic market, and nearly what we have worldwide.

Lewis: Which is absolutely crazy. And it doesn't seem like Netflix will get any meaningful exposure to this market, but with the possibility of iQiyi being spun out and run as its own public company at some point, we might get a little more flavor for what those types of deals look like for Netflix, and what the appetite for streaming content looks like in China going forward. Because, eventually, I have to think Netflix is going to want a slightly larger piece of that pie, and try to figure out how to make that happen.

Vena: I know they've been working on it, and Reed Hastings and the company has said in the shareholder letter that they just don't have a way into the country, at least not meaningfully at this point. They have the licensing deal with the iQiyi service, they may be able to license some content with some other providers there. But for the time being, the rest of the world is their oyster.

Lewis: That's still plenty to work with, though, isn't it, Danny?

Vena: It is. You have 7 billion people on the planet. If you take out the population that really can't afford Netflix, that still leaves several billion people as a potential customer base.

Lewis: Yeah. And based on some estimates, it seems like they're going to have to reach quite a bit of that customer base to live up to their current valuation. But, that means there's a lot of room for them to grow.

Vena: It does. And like you said, there's two different levers that they pull. The first lever is, they continue to add subscribers, that subscriber growth has been growing remarkably quickly internationally. The second lever is, over time, as they get more customers and become more mature in some of these international markets, they increase the price a little. I think the sky is the limit for Netflix.

Lewis: Anything else on the company or the upcoming earnings report before I let you go, Danny?

Vena: I'm excited to see what happens. Netflix underestimated last quarter a little bit. They got far more subscribers. I think they estimated just over 3 million, and they ended up with 5 million. I think part of that had to do with the timing of some of the releases of their original content. But, I'm excited to see what they do for subscriber numbers this quarter, if they just beat it or blow it out of the water.

Lewis: We'll have to wait and see. Thanks for hopping on, Danny!

Vena: Thanks. Have a good rest of your day!

Lewis: You too. Listeners, that does it for this episode of Industry Focus. If you have any feedback or questions for us, you can always shoot us an email over at [email protected], or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes or check out the Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass. For Danny Vena, I'm Dylan Lewis. Thanks for listening and Fool on!