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.
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.
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.
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.
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.
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.