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Wednesday, July 30, 2014

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  • Netflix Q4 Results Improve, But It's Not Time to Pop the Champagne Just Yet

    Netflix reported its Q4 '12 results late yesterday, adding 2.05 million domestic streaming subscribers, 1.81 million international streaming subscribers and losing 380K domestic DVD subscribers. All of these numbers were slightly better than the high end of the guidance range that Netflix provided with its Q3 report back on Oct. 23rd. Netflix also reported an $8 million quarterly profit globally, compared to its forecasted range of a loss of $13 million to a profit of $2 million.

    Predictably - and just as happened a year ago when Netflix reported a relatively strong Q4 '11 - this morning's headlines are touting the company's turnaround (a sampling of what I've seen: "A Resurgent Netflix Beats Projections, Even Its Own," "Netflix's Q4 restores company's investment luster," "Netflix Posts Surprise Profit," "Netflix smashes street expectations," etc.). Investors are even giddier, sending Netflix's shares up more than 44% this morning.

    To be fair, after the horrendous period beginning in mid-2011, with the ill-fated Qwikster and aggressive rate increase decisions, the Q4 results are quite heartening. Domestic streaming subscriber additions were at their best level since the heady days of Q1 '11. DVD subscription losses slowed to their lowest level since the losses began following Qwikster. And international turned in its best quarter of subscriber acquisitions to date. Management also said that churn is improving and international payment issues are being resolved.

    Nonetheless, and at the risk of sounding like the "skunk at the picnic," I think there are still some key open questions for the company, which I would generally put into 3 buckets:

    1. Domestic streaming subscriber growth and size of market
    Netflix management has said in the past (and reiterated yesterday) that it sees its long-term domestic market opportunity as being 2-3x that of linear HBO. Since HBO has approximately 30 million U.S. subscribers, that suggests Netflix believes it can grow to 60-90 million domestic streaming subscribers long-term.

    There's no question over-the-top video services like Netflix are extremely compelling to consumers, but it's hard to know yet what the true size of the market is or what the adoption rate will be. Netflix's 2012 quarterly performance attests to this. At the beginning of 2012, Netflix asserted it would add 7 million domestic streaming subscribers in 2012. By its July 24th shareholder letter, it was moderating expectations, saying that it would have to meet the high end of its Q3 guidance of 1 to 1.8 million subscriber adds to still achieve 7 million for the year (it ultimately added just 1.16 million in Q3, the bottom of the range). Then, in its Q3 letter, it reduced the high end of its Q4 forecast by about 900K subscribers to 27.1 million, which it ended up narrowly beating yesterday.

    In all, Netflix gained 5.48 million subscribers in 2012, 22% below its original forecast. As a result, it grew domestic streaming subscribers by 25% in 2012 - not shabby at all - but less than the 32% it intended and a world away from its growth spurt from Q1 '10 - Q2 '11. If Netflix can add 5.5 million subscribers each year, it would hit 60 million (2x HBO's total) by end of 2018. If it could grow 25% per year, it would hit it by 2016, though that would mean adding over 10 million subscriber per year, which is more than it's ever done. The point here is that it's still very early days for understanding streaming's true potential. Even Netflix's management is feeling its way along, as it readily admits.

    2. Content and Competition - the 2 big drivers
    Without a doubt, the 2 biggest drivers affecting Netflix's domestic subscriber growth are its content selection and what happens with the competition. On the content side, Netflix continues to invest aggressively, with the Disney output deal, and the originals slate, headlined by the Feb. 1st debut of "House of Cards," being the most prominent examples. But while better content should drive more subscriber acquisitions and better retention (if not, then why bother?), in the call yesterday management says it's taking a very conservative posture, not modeling any incremental subscriber growth due to upcoming originals.

    Meanwhile, a competitive dogfight is emerging between Netflix and Amazon for content rights. Though Netflix published an infographic in its letter showing that Amazon Prime offers just 73 of Netflix's top 200 most-watched TV shows and movies in Q4, the reality is that a year earlier, the number probably would have been in single digits. The fact is, Amazon is investing aggressively to catch up to Netflix, and if it ever fixes its underwhelming UI, will become even more competitive. Other competitors also loom - Hulu Plus, Redbox, TV Everywhere, etc. - for sure none yet a true substitute for Netflix, but all clouding the consumer's decision-making a little further. What transpires with the competition - specifically regarding content acquisitions - will surely impact Netflix's growth prospects.

    3. International losses
    The biggest question mark for Netflix revolves around its extremely expensive international expansion. In Q4, international continued to cost Netflix more than $2 for every $1 of revenue it generates ($105 million in losses on $101 million in revenue). International contribution losses for 2012 totaled $389 million, more than wiping out the $350 million in contribution profit domestic streaming generated (once again, thank heaven the DVD business, even in its shrunken state, is still around to act as a cash cow!).

    Netflix said it won't roll out any new international markets in Q1 '13, no doubt a relief to investors who continue to see a river of red ink flowing from the company's international forays. The problems in international are that Netflix is up against formidable, entrenched competitors who have locked up a lot of content and it doesn't have a DVD business or well-known brand, as it did in the U.S., to leverage.

    Curiously, Netflix's guidance for Q1 is to add between 480K and 1.18 million subscribers internationally, below the 1.21 million it added in Q1 '12. None of the analysts on the call asked about this, but it does seem odd that additions would slow as its brand presence grows in international markets. What would cause this? From my standpoint, while there's uncertainty about domestic streaming growth, international is virtually a "black box" at this point. When, how and even if, international will get to break-even as a whole remains a complete unknown.

    As VideoNuze readers know, in the past year-and-a-half I've been extremely critical of Netflix's decision-making, in particular regarding its proactive choice to de-emphasize DVDs. Had Netflix stayed the course on DVDs it would be a far stronger company today, with much greater financial and competitive leverage. In 2012, Netflix earned just $17 million on revenues of $3.6 billion, for a net margin of less than .5%. How much growth and profitability are ahead remain the over-arching questions Netflix must answer each quarter. It's great to see Netflix clawing its way back from the depths, let's see how the story continues to unfold.

     
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