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.