Netflix Q1 15A – The balance of power

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Everything depends on Netflix achieving scale.

• Netflix reported Q1 15A results slightly below expectations but the subscriber growth was better than forecast and this continues to be the main driver of the shares.
• Q1 15A revenues / EBIT were $1.57bn / $97.5m compared to consensus at $1.57 / $106m but all the attention was on the subscriber count.
• Netflix added 2.28m subscribers in the US and 2.60m elsewhere to bring the total to 62.27m of which 59.62m (96%) are paying subscribers.
• Total net additions of 4.88m subscribers in Q1 15A was ahead of company guidance of 4.1m which has been attributed to NetFlix’s increasing stable of exclusive shows headlined by House of Cards.
• The company is starting to see some benefits of scale as gross margins in the US improved to 31.7% ahead of company guidance at 30.1%.
• International, with its much smaller user base continued to see negative gross margins.
• Guidance was pretty cautious with 2.5m net additions expected and revenues / EBIT of $1.47bn / $59 compared to consensus of $1.66bn / $132m.
• This did nothing to halt the unbridled optimism based on the user numbers that sent the shares up 12% in after-hours trading.
• As Netflix grows its user base and relies more heavily on its own, exclusive content, three main dynamics driving the business model emerge.
  • First. Netflix is becoming similar to a software company.
  • Netflix incurs low additional costs to deliver its exclusive content to additional users.
  • This means that if the company can continue to increase its user base then substantial improvements in gross margins are probable.
  • They are never going to reach the 90% that Microsoft can earn as the cost of delivering the content is a meaningful factor, but they should be able to reach levels far above where they are today.
  • Second. Netflix is becoming a data company.
  • A significant percentage of the domestic market are using its service and critically it knows far more about its users than the cable or satellite companies do.
  • This data gives Netflix the ability to suggest and curate content that it knows that its users will like based on their viewing habits.
  • This will mean it knows exactly to whom to market its new and existing shows making marketing much easier and much more efficient.
  • Netflix currently spends 12.3% of revenues on marketing which I think could be meaningfully brought down over time.
  • This data could also be used for advertising and a free tier of service but given almost everyone pays for the service today, this is unlikely to happen any time soon.
  • Third. If subscribers continue to grow, then the balance of power will begin to shift in its favour.
  • Content creators will increasingly realise that they have to have their content on Netflix to reach the mass market giving Netflix much more power when it comes to content rights negotiations.
• All of these factors should have a positive impact on gross margin and OPEX over the long term but are completely dependent on Netflix’s ability to reach critical mass.
• RFM’s ecosystem research strongly suggests that this critical mass will start to really factor in gross margin when the company passes 100m subscribers.
• Netflix is now trading on 162x and 108x 2015E and 2016E PER and 4.8x and 3.9x 2015E and 2016E EV/Sales indicating that much of this margin story has already been priced in.
• The revenue and critical mass element has clearly not been priced in, and this could be a source of upside if it becomes clear that Netflix will pass 100m subscribers.