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Netflix (NFLX +3.32%) stock is under heavy selling pressure lately. Shares of the online video leader are down by more than 30% from their highs of the last year, mostly on fears of rising costs and increasing competitive pressure. However, while these are relevant risks to watch, Netflix still offers enormous potential for growth in the years ahead.
International growth is expensive
Netflix seems truly unstoppable in its quest for world domination. The company ended the fourth quarter of 2015 with 74.76 million streaming members around the planet, and it gained 5.59 million new members during the quarter. Growth is slowing in the U.S., but opportunities for international expansion look hotter than ever, especially since Netflix recently entered 130 new countries.
Netflix is now available in every major market in the world, except for China. The company has added 190 million broadband homes to its addressable market, bringing the total addressable base to nearly 550 million homes. Since Netflix has roughly 75 million subscribers, this means the market penetration level is only 13.6% of the addressable market at this stage.
Most of the company's growth is coming from overseas. Netflix added 4.04 million international members last quarter, a big acceleration versus 2.43 million new members in the fourth quarter of 2014. Management guidance is for 4.34 million new international subs and 1.75 million new U.S. members during the first quarter of 2016.
Global markets represent a promising growth venue for Netflix over the coming years. However, international expansion is also quite expensive, and this is hurting profit margins. The company reported a negative contribution margin of 19.2% in international markets last quarter, and chances are that Netflix will continue losing money in this segment during 2016.
Rising competitive pressure
Increasing competitive pressure from players such as Amazon.com (AMZN +3.64%) and Time Warner's (TWX +0.00%) HBO is another reason for concern among investors. Amazon doesn't disclose the exact number of Prime Video subscribers it has, but the company is well known for its relentless competitive drive and its willingness to spend big sums of money to steal market share away from the competition. Amazon is expanding into original programming with successful productions such as Transparent, and the company reportedly spent a whopping $15 million for Woody Allen's next movie. Competing against Amazon is no easy task, not even for an industry pioneer such as Netflix.
HBO owns enormously popular titles such as Game of Thrones, and Time Warner recently decided to offer HBO as a stand-alone streaming service via HBO Now. Time Warner management said in the latest conference call that HBO Now had 800,000 subscribers as of the end of 2015. While this doesn't look like a big threat to Netflix at this stage, HBO is not a competitor to disregard. In fact, Netflix has always identified Time Warner's HBO as its closest competitor.
Time is on your side with Netflix
Competitive pressure is on the rise, but that's no reason to sell Netflix stock. Just as traditional TV has allowed several companies to do well in the industry, online TV will most likely offer enough room for multiple players to succeed over the long term. Because different online streaming services offer different content, they aren't necessarily direct substitutes for each other.
Netflix is planning to release 600 hours of original programming in 2016 -- a remarkably smart strategy. Original content has been especially successful among subscribers, and it also differentiates Netflix from the competition, providing a tremendously valuable source of competitive advantage in the industry. Importantly, the company is developing original content specifically targeted toward global markets: Netflix is producing Marseille, a French political drama starring Gerard Depardieu, and it's also working on local-language shows in countries including Italy, Japan, Mexico, and Brazil.
While profit margins will probably remain under pressure in international markets over the coming quarters, Netflix is making tons of money in the United States. The contribution margin in the U.S. came in at 34.3% of revenue in the fourth quarter of 2015, a significant increase from 28% in the fourth quarter of 2014 and 32.4% in the third quarter of 2015. Management believes the business is on track to produce a contribution margin of 40% of revenue in the U.S. by the year 2020.
Total streaming contribution margin, which includes both U.S. and international markets, was 16.2% during the fourth quarter of 2015, and management is anticipating a slight increase to 16.7% of sales in the first quarter of 2016. Even if international expansion is weighing on overall profitability, the situation is not too bad at all for the company as a whole.
The main idea is that Netflix is proving to investors that it has a viable business model producing rising profitability in mature markets. The company expects to produce material profits from the international segment in 2017, and this would be a major positive for investors, not only because it would generate big profitability at the overall company level, but also because it would dissipate a lot of fears and doubts about the company's ability to make money in international markets.
Netflix operates in a very dynamic environment. Competition will probably continue increasing in the future, and profit margins are hard to predict in the short term. On the other hand, this amazing growth story remains intact from a long-term point of view. If anything, the recent decline in Netflix stock looks like a buying opportunity for investors.
