Tuesday, May 7, 2013

Netflix Is Changing Fast

Netflix (NFLX) is an interesting business to investigate, as its revenue and stock price have been quite volatile. A look into the Q1 2013 results for Netflix NFLX shows that their three avenues of business (domestic streaming, international streaming and domestic DVD) have changed quite a lot over just the past year. And while in the past NFLX concentrated on their domestic markets (streaming and DVD), it is now also working hard to bring its international streaming revenue up to scratch. We can see that there is now a clear trend of declining domestic DVD revenues, increasing domestic streaming revenues, and increasing international streaming revenues.

Domestic Streaming Revenue Growth

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In regards to its domestic streaming segment, it would appear that NFLX has been making all the right moves lately. In Q1 2013, for the first quarter ever, profits from domestic streaming ($131 million) exceeded profits from domestic DVD's ($113 million). This could partly be attributed to NFLX's exclusive content (especially the new show House of Cards) that brought in many new members, and improved member satisfaction as NFLX continues to improve their service. I believe that making a multi-year deal with Time Warner (TWX) for new shows will be a large driving force for retaining members and attracting new members and we will see numerous shows available for streaming on NFLX in future, including Revolution (NBC), The Following (Fox), Longmire (A&E) and Political Animals (USA). NFLX management predicts that domestic streaming revenue will continue to increase in Q2 2013.

International Streaming Revenue Growth

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The newest segment for NFLX, international streaming represents an enormous new market, as roughly only 10% of the world's ~2.4 ! billion total internet users are based in the USA. NFLX has been aggressively marketing their international streaming service and has grown their international streaming revenue very quickly: in Q1 2012, international revenue was only $43 million, whereas in Q1 2013 it was $142 million. Perhaps most importantly, the losses for international streaming have declined, with $77 million lost in Q1 2013 compared to $103 million lost in Q1 2012. It is to be expected that losses will take place during the early stages of a new service being introduced - NFLX was, in fact, losing money for a long time before they reached profitability with their main domestic services. But if the trend for international streaming continues, we could see this segment of NFLX become profitable within the next couple of years, and then it could become one of the main money-makers for NFLX. NFLX management forecasts losses of $65 million to $81 million for international streaming in Q2 2013, and I expect this to decline in further quarters.

Domestic DVD Revenue Growth

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The domestic DVD segment of NFLX enjoys very high profit margins (in Q1 2013 the contribution margin for Domestic DVD was 46.6%, representing contribution profit of $113 million) compared to domestic streaming. But while domestic DVD is a very important segment for NFLX that has brought in very healthy profits, it has very clearly declined over the past year, and it seems very likely that it will continue to decline (NFLX management forecasts domestic DVD contribution profit of $100 million to $112 million in Q2 2013). I cannot think of how NFLX could improve this segment of their business and turn the trend around to bring up domestic DVD revenue to its previous highs.

What's In Store For NFLX?

The numbers for NFLX tell a very clear story - streaming is growing, while the older domestic DVD segment is declining. I believe ! technolog! y is the main cause for this shift. Broadband internet has become far more common since NFLX first started, and consumers now have access to far cheaper internet plans with faster speeds and higher data allocations. That allows them to stream television shows with ease, and watch shows immediately. Having a DVD sent in the mail is, by comparison, slow, expensive and cumbersome. We have already seen how the internet has affected traditional video-rental stores such as Blockbuster from DISH Network (DISH). Just like the music industry (where record stores and album sales were dominant before internet use was widespread), the industry for NFLX has changed substantially since its inception, and NFLX has to recognize these changes and adapt.

For NFLX investors, the most exciting segment of the business to watch for the remainder of 2013 and beyond will be international streaming. This will represent the strongest growth potential compared to the already relatively mature domestic streaming and DVD revenues. NFLX is present in Latin America, Europe and Canada, and these markets should supply millions of new customers in the coming years. But just as how it took many years for its domestic streaming and domestic DVD segments to become profitable, international streaming is very unlikely to become a huge success for NFLX in the short term. NFLX shareholders will therefore need to remain patient as international streaming grows for NFLX and slowly begins to add to its bottom line.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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