Tuesday, April 22, 2014

NFLX: Good Q1 results; planning to increase prices

Netflix (NFLX) reported better-than-expected Q1 '14 results on Monday.  Margin improvement was apparent in domestic and international streaming businesses (with international coming in at a loss), in addition to the DVD business.  DVD margin still remains nearly twice the domestic streaming margin.  All of this was good news as the stock was up nearly 7% AH. 

However, NFLX also announced its plan to raise monthly subscription prices by $1 - $2, but did not say exactly when it will do so.  We discussed that this will have to be considered by the Company in our post regarding Amazon's Fire TV announcement.

NFLX is raising its prices because the better content it needs to purchase and/or 'co-produce' is becoming more expensive.  We think the Company has realized it cannot pass all of the higher costs to the Internet service providers (NFLX also complained about that), therefore it is kindly giving some of it to the consumers by raising prices and potentially adding to its tiered pricing.  NFLX is doing this gradually.  In addition, initially only new subscribers will have to pay more.  But we think the ones 'grandfathered in' will also pay more later down the road, and that price increase will be masked effectively as the Company will likely present it as tiered pricing.  

The short-term impact of the pricing announcement will drive many to subscribe before prices increase, which may push Q2 subs higher than analysts expect.  However, in the long-run, we believe higher prices will increase NFLX subscriber churn (for which NFLX no longer provides numbers; and management no longer uses the word "churn", instead it indirectly refers to it by using the term "member satisfaction") and will force the Company to spend more on marketing and continue to pay higher prices for better content.  We note that the contribution margin expansion seen in Q1 '14 was mainly due to lower cost of revenues, which may be surprising, but not to us.  As usual, NFLX management is trying to manage Wall Street expectations.  Simply put, costs of revenues (mostly content costs) did not decline, management just "managed level of content growth".  And now that it needs to grow content, it has to raise prices.  We think NFLX fears it will face increasing marginal costs, possibly slowing down the margin expansion we have seen lately, unless it increases prices.  Sell-side analysts' expectations are managed very well.

NFLX also took a shot at AT&T for its slow ISP performance.  Unfortunately, NFLX also set a precedent earlier this year as it signed a deal with Comcast (CMCSA): it is willing to pay ISPs more for better performance.  We are assuming that AT&T doesn't mind Hasting's 'outburst'.  

We believe Hastings' main strategy is to throw the ISPs at each other and to hopefully drive consumers to bark a bit louder.  This was apparent as he also made negative comments about the potential CMCSA and Time Warner Cable (TWC) merger.  Now, Hastings is hoping he can just sit back and watch T, CMCSA, and other service providers wage a more aggressive pricing war against each other, so that if prices decline, it may partially offset impact of NFLX's price increase on subscribers.  While all of this is fun to watch, we do not agree with Hastings' argument: a CMCSA/TWC merger will make CMCSA "the only option for truly high-speed broadband".  T, Verizon (VZ), and many other ISPs can serve the same markets.  And as CMCSA also said: "Internet interconnection has nothing to do with net neutrality; it’s all about Netflix wanting to unfairly shift its costs from its customers to all Internet customers, regardless of whether they subscribe to Netflix or not."  We proudly say that we have basically said the same thing before.  The entire CMCSA response to NFLX's opposition to the merger is on CMCSA's website: http://corporate.comcast.com/comcast-voices/comcast-response-to-netflixs-opposition-to-time-warner-cable-transaction

Assuming EBITDA margin expands rapidly to 10%+ this year (from around 6% in 2013), approx. 15% in 2015, and 17% in 2016, which will be very impressive, based on Monday's closing price, NFLX is trading at 36x, 22x, and 16x 2014, 2015, and 2016 EBITDAs, respectively. 

No comments:

Post a Comment