Shares of Netflix, (NASDAQ:NFLX) have been on an absolute tear for the past 2 years. Netflix stock bottomed out at less than $60 in late 2012 after reaching a high of more than $300 the previous year. Since then, the stock has soared more than 750% to approximately $480!
Considering how far Netflix stock has rallied in the last 2 years and the fact that the company trades for more than 120 times expected 2014 earnings, Netflix shares may have gotten ahead of themselves.
Still, if Netflix can keep up its nearly flawless execution, the stock could continue to go higher. Here are 3 important reasons why Netflix stock could continue delivering nice gains for long-term investors.
Domestic subscriber growth
Despite increasing its penetration of the U.S. market significantly in the past few years, Netflix continues to generate strong domestic subscriber growth. At the end of 2011, Netflix had fewer than 22 million domestic streaming subscribers.
The company then added 5.5 million domestic streaming subscribers in 2012 and another 6.3 million in 2013. Year-to-date, Netflix has added domestic streaming subscribers somewhat faster than the 2013 pace. This puts Netflix on pace to reach about 40 million domestic streaming subscribers by year-end: nearly 45% of all U.S. households with broadband Internet.
Netflix's rapid domestic subscriber growth is a critical part of the bull case because it allows Netflix to spread its content and advertising costs over more subscribers. (By contrast, expanding to new markets can also drive revenue growth, but Netflix has to incur additional costs to buy content licenses for each new country.)
As a result, Netflix's penetration of the U.S. broadband household base has driven solid margin growth. In Q4 of 2011, Netflix reported a domestic streaming "contribution margin" of just 10.9%. By Q2 of 2014, that had risen to 27.1%. Netflix expects its domestic streaming contribution margin to surpass 30% in 2015.
Higher average prices
Higher average revenue per user could give Netflix's profit margin a further boost in the coming years. In May, Netflix announced that the price of its classic streaming plan (which permits up to 2 simultaneous streams and includes HD) would increase from $7.99 to $8.99 for new users. Existing customers were grandfathered into their old rates for at least 2 years.
At the same time, Netflix added a basic plan that offers streaming in standard definition on one device at a time for $7.99. Including Netflix's 4-stream plan for $11.99 (introduced last year), the company now offers 3 tiers of service to address different users' needs.
These pricing changes will gradually increase Netflix's average revenue per user -- especially after the price increase kicks in for existing subscribers (probably in 2016). That means Netflix will have more revenue for any given number of subscribers, but essentially no additional costs. That's a recipe for additional margin expansion.
As noted above, Netflix's global expansion isn't likely to improve its profit margin anytime soon. Indeed, the company's international operations have generated a cumulative loss of more than $800 million. Expanding more broadly in continental Europe will lead to further losses for the next couple of years.
Longer-term, though, Netflix's international markets could prove to be just as profitable as the U.S. (The consistent improvements in international profitability are a clear positive sign.) Each new country launch expands Netflix's total addressable market, and international revenue could eventually be 2-3 times higher than domestic revenue, according to Netflix executives.
As international markets go from being a significant drag to being consistently profitable, Netflix should see a rapid acceleration in earnings. In fact, the progression of international markets to consistent profitability could have an even bigger impact on Netflix's financial performance than the potential improvements in Netflix's domestic contribution margin.
The combined effect of continuing domestic subscriber growth and higher average prices should lead to further gains in Netflix's domestic contribution margin. Meanwhile, international expansion will allow Netflix to grow its long-term revenue base. As these international markets turn profitable, Netflix's earnings may surge.
That said, valuation is still a significant concern for potential Netflix investors. At some point in the future, Netflix's growth will moderate. When it does, the company's P/E ratio will probably recede to a more typical level. At Netflix's current price, only a truly extraordinary level of earnings growth will produce good results for long-term investors.
The 3 factors highlighted above could potentially deliver the necessary growth to justify Netflix's high multiple. However, long-term investors should recognize that strong earnings growth over the next 5-10 years does not guarantee strong stock performance for Netflix.
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.