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Netflix Inc Investors Are Missing the Big Picture

By Jeremy Bowman - Oct 29, 2015 at 10:00AM

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International subscriber growth is more important to watch than domestic performance.

Netflix Inc (NFLX 5.03%) shares are down 10% since the leading streamer reported earnings earlier this month. 

The culprit was weaker-than-expected U.S. subscriber growth as just 880,000 signed up for the entertainment service in the third quarter, falling short of the company's own forecast of 1.15 million. The stock, which had more than doubled this year, unsurprisingly took a hit.

Analysts claimed that the recent onslaught of over-the-top offerings is making Netflix less appealing to new customers. Hulu introduced in ad-free platform for $11.99/month. Time Warner's (TWX) HBO released HBO Now and the spring, and, following its Emmy's sweep, is likely to gain some more stand-alone sign-ups. (AMZN 3.58%) continues to juice its Prime Instant Video signing up such big names like Woody Allen and Spike Lee for exclusive productions, and CBS (PARA 5.06%) launched an over-the-top option for Showtime in July, throwing a bone to fans of shows like Homeland and The Affair. But Netflix CEO has long persisted that linear TV-the cable and satellite providers-are the real competition, and Netflix has maintained a dominant position in streaming. While Netflix now 43 million paying subscribers, Hulu has just 9 million as of the end of last year. 

But the international market constitutes another where Netflix is building out a competitive advantage.    

In lieu of consistent or meaningful earnings from the House of Cards-maker, the market has instead focused on domestic subscriber growth as the best reflection of its underlying strength. That's understandable as domestic streaming has been the company's focus for the last five years or so, but that view is becoming short-sighted as Netflix transitions into a global business. The company's prospects abroad are harder to synthesize, but ultimately, they will determine its future success.

The streaming provider landed in Japan in the third quarter and is set to launch in Spain, Portugal, and Italy this week. It's rapidly approaching its goal of worldwide expansion by the end of next year. Its debut in South Korea, Hong Kong, Taiwan, and Singapore is on the horizon for early next year, and with it, it will essentially complete its expansion into the developed world. China remains a question mark, but any progress in that area would be a positive for the stock.

The final frontier
It's clear now that Netflix will derive a majority of its subscribers from international markets, possibly as soon as 2017. 

Last quarter, Netflix's international growth exceeded expectations, adding 2.74 million members against a forecast of 2.4 million, and with a forecast of 3.5 million new members in the fourth quarter, the company is on track to add 11 million subscribers outside of the U.S. this year. That's nearly double the 5.7 million domestic subs it expects to add this year. 

Internationally, profits are still lacking. As the company prepares to launch in new countries and spends heavily on marketing, it is currently losing money on its overseas expansion. However, mature markets are profitable, and management, which avoids giving details on specific markets, has said that contribution profit in Canada, the first international market it entered, is similar to the U.S.

As the company completes its international expansion, it expects to deliver material profits, beginning in 2017. Currently, marketing expenses take up a disproportionate percentage of revenue abroad compared to domestic. Last quarter, it spent just 7% of domestic streaming revenue on marketing, but international marketing took up 26% of foreign revenue. Had the company's marketing spending abroad matched its domestic level, it would have delivered a contribution profit of $30 million instead of a loss of $67 million last quarter. 

Over the next few years, as the company completes its international expansion, that marketing spend should normalize, helping to drive profitability abroad. At the same time, its growing subscriber base will lower the percentage cost of its content.

What a profitable Netflix will look like
Management has recited many times its goal of a 40% domestic contribution margin by 2020. Considering contribution margin is tracking at 33% for this year, it may exceed that, but we'll assume 40% for the sake of forecasting.

Including this year, Netflix has added about 6 million domestic subscribers a year for the last four years, and it's set to finish 2015 with 45 million members. Assuming it adds an average of 5 million members for each of the next five years, that would give it 70 million domestic subscribers. Members on average are paying $10/month for the service today. By 2020, a conservative projection would be $12/month. Given those figures, Netflix's domestic contribution profit would look like the following:

Domestic Membership Annual Charges  Domestic Revenue Contribution Margin Contribution Profit
70 million $144/year $10.1 billion 40% $4 billion

Internationally, meanwhile, Netflix could hit 100 million members by 2020, which would mean an average addition of 14 million a year for the next five years. Given the rapid increase to 11 million this year, and the addition of more countries in 2016, a growth rate of 14 million a year should be attainable. International members are paying less today, about $8.60/month, which, with modest inflation and price increases, should easily rise to $10/month by 2020. Considering Netflix's domestic contribution margin today is over 30%, a goal of 30% for its international segment by 2020 seems within reach. The chart below shows the resulting contribution profit.

International Membership Annual Charges International Revenue Contribution Margin Contribution Profit
100 million $120/year $12 billion 30% $4 billion

Assuming $2 billion in technology and general and administrative expenses, and a 33% tax rate, Netflix would make $4 billion in net income in 2020. At a P/E of 25, that would give the company a valuation of $100 billion, or 2.4 times its current worth. 

Opportunities such as original movies like "Beasts of No Nation" could add revenue, technological advances could also open up new revenue streams, and the Chinese market remains a big question mark. 

The future for Netflix is rosier than analysts would claim following its most recent report, but measuring its value remains difficult. Though its international segment won't generate meaningful profits for at least another year, Netflix investors would be mindful to focus on subscriber growth outside of the U.S. as that is the company's biggest opportunity.

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