Outlook: Netflix Faces Slow Domestic Growth and Increased Costs
Q4 results exceed expectations from subs growth and margin. Revenue was $1,175 million versus our estimate of $1,164 million, and consensus of $1,166 million. It did not provide revenue guidance. Domestic streaming, domestic DVD, and international streaming subs figures all exceeded our expectations. EPS was $0.79, versus our estimate of $0.60, consensus of $0.66, and guidance of $0.47 – 0.73, driven by top-line growth and better-than-expected gross margin.
Contribution profit for Netflix’s (NASDAQ:NFLX) domestic and international streaming businesses has steadily improved. In the last eight quarters, the contribution margin for the domestic streaming business has increased to 23 percent from 14 percent, and for the international streaming business to (26) percent from (240) percent, demonstrating some leverage from lower marketing spending and impressive control over content spending, at least in the short-term. We continue to believe that lower content quantity will lead to fewer subscribers joining the service longer-term.
We expect domestic streaming subscribers to continue to grow for the foreseeable future as more original content becomes available. For Q1, Netflix guided to domestic streaming subscriber net additions of 2.25 million, compared to 2.03 million last year, helped by the positive impact of seasonality. International expansion should continue as domestic growth slows, but it will likely weigh heavily on consolidated contribution profit for the foreseeable future.
We view the recent net neutrality ruling as a negative, and management appears to us to be almost naively unconcerned. We believe the average Netflix household consumes over 100 GB per month, and believe the average Internet service bill is around $50 per month, meaning consumers pay $0.50/GB for access to Netflix. This suggests to us that ISPs will be reluctant to charge users more, but will be unconcerned about charging Netflix a nominal amount, likely $0.01/GB. At that level of fees, we estimate Netflix would be required to pay approximately $360 million per year, two-thirds of 2014 consensus EBITDA.
Maintaining our UNDERPERFORM rating, we are raising our 12-month price target to $175 from $160 to reflect strong Q4:13 results and Q1:14 guidance. Our PT reflects a sum-of-the-parts valuation of domestic streaming, international streaming, and domestic DVD. We believe Netflix’s high valuation is unwarranted given potential for slowing domestic growth, coupled with increasing content costs.
Michael Pachter is an analyst at Wedbush Securities.