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Netflix's (NFLX) ballooning subscriber base, corresponding outsized earnings growth, and potential for further success explains much of the 215% appreciation of its stock price over the past year. The company added 1.9 million subscribers in the September quarter, marking it the fourth consecutive period with over one million net additions. The total tally now stands at 16.9 million accounts, 52% more than last year's third quarter and 13% higher than the June period. Nielsen estimates there are 116 million households with at least one TV, giving Netflix a penetration rate of 14.5%, compared to 9.5% at the end of 2009's third quarter. These figures have not gone unnoticed by investors. NFLX stock recently traded at $178.45 a share, or 57x our forward share-earnings estimate of $3.11, versus the historical range of 20x-25x.

The primary explanation behind Netflix's rising popularity is the rapidly expanding number of movie and television titles available in its Watch Instantly library, which allows users to stream videos to flat screens, tablet PCs, laptops, desktops, and smartphones whenever they choose. Management recently reported that over 66% of Netflix subscribers watched more than 15 minutes of a streamed TV episode or movie in the third quarter of 2010, up from 41% last year and 61% in the prior period. Furthermore, the total number of minutes people spend consuming streamed content has surpassed that of conventional DVD watching (assuming every shipped disk is watched only once). This is not being driven by outliers, since the majority of Netflix users now stream more content than watch DVDs. Perhaps the headiest statistic comes from networking equipment maker, Sandvine, which reports that Netflix's streaming service accounts for 20% of all nonmobile Web use during prime time in the United States.

Streaming Movies

CEO, Reed Hastings, has made it no secret that in order to maintain current subscriber growth rates, Netflix's primary focus will be on expanding the breadth and timeliness of its streaming library. This will likely prove expensive, if future content deals mimic the widely reported $1 billion, five-year agreement with premium TV channel Epix inked in early August, 2010. This deal gives Netflix the rights to stream 3,000 movies at present, with more to come later. Normally, Epix would keep exclusive TV rights to broadcast movies that are 10-12 months out of theaters for up to several years before selling to cable networks. As a result, Netflix is paying a rate close to what conventional TV distributors pay Epix in affiliate fees. Although Netflix doesn't get access to newly released content until 90 days after its pay-TV debut, it does have access to a broad set of library titles that pay TV can't provide.

The next major deal on the docket is a renegotiation with Liberty Media-owned Starz in late 2011. Starz content includes over 2,500 movies and shows from Disney (DIS - Free Disney Stock Report), Sony Pictures, and other sources, which helped attract scores of new subscribers after the first deal was struck in 2008. We estimate that Netflix currently pays Starz only $0.15 per subscriber per month, and doesn't have to wait for three months to access new releases. The rate is low compared to the Epix deal. At the time the initial contract was signed, the established streaming customer base was small and the price of content did not scale with the addition of new users. Starz realizes it has been under compensated, thus far. At the very least, it will need to charge Netflix the same rate as the cable, satellite and fiber-TV providers (around $2.00 per subscriber per month), or risk angering these customers and getting removed from their distribution networks.

We believe Starz will end up charging significantly more than Epix, perhaps as much as $250 million per year, since the content is arguably of higher quality and includes more new releases. Netflix management appears eager to renew, but also willing to walk away if the price is too high. Mr. Hastings has said this about Starz content: "There's no one piece of content that's essential for us. It's great content, we'd like to have it, but we can live without it if we have to." If the deal fell through, we believe Netflix's churn rate would rise and subscriber growth would slow, since many families that want to stream Disney content would likely leave or not sign up.

Meanwhile, HBO has deals with 20th Century Fox, Universal, Warner Brothers, New Line Cinema, and DreamWorks that are not set to expire until mid to late decade, suggesting any future movie deals that Netflix may ink will likely be with small, independent studios like ones reached with Relativity Media in July and FilmDistrict in December.

Streaming Television

The next big expansion area for Netflix is its TV offerings. Indeed, the majority of content United States consumers view at home is TV programming, and this is where the company has the best chances of securing licensing. There have been reports that Netflix is attempting to buy streaming rights to current season shows the day after they are broadcast for $70,000 to $100,000 per episode. We are skeptical that content creators will be willing to risk syndication revenue and ad dollars that would surely be disrupted by allowing Netflix to stream popular shows that are in-season. Too, this would likely cannibalize viewers of Hulu Plus, the online streaming TV service that provides the current season of 45 shows and the full-run series of 90 other shows from NBC ABC and FOX for $7.99 per month. At present, we view the two services are more complimentary than competitive, since only around a quarter of content overlaps.

We think any success in securing in-season programming will be with lower profile shows. For example a deal was recently reached with NBC for rights to stream Saturday Night Live episodes the day after the original broadcast. Too, in early December, Netflix struck a deal with Disney-ABC Domestic Television for some ABC Family and Disney Channel programs 15 days after initial telecast. Studios appear much more willing to negotiate rights to shows that are more than one season old, which management admits is its primary area of focus. Both of the mentioned contracts also include rights to stream the libraries of hit shows such as 30 Rock, The Office, Law & Order: SVU, Scrubs, Grey's Anatomy, Desperate Housewives, Lost, and Ugly Betty, among others.

The company hopes these deals will attract more subscribers and increase cashflow, thus supporting growth. Netflix seems confident in the amount of TV content available that it can purchase. The big unknown is when will the market for prior-run TV shows and older movies become mature. At this point, the company is not willing to speculate. Nonetheless, it seems confident that subscriber growth of better than 50% is sustainable over the near term.

Other Venues

Increased penetration into consumer electronic devices will likely help facilitate the prospective advance. The service is already available on a myriad of devices, including Nintendo's Wii, Microsoft's (MSFT - Free Microsoft Stock ReportXbox360, and Sony's (SNEPlaystation 3, as well as numerous Blu-ray players, Google (GOOG) TV devices, and the iPad and iPhone (Android smartphones will soon be compatible, as well). We think this gives Netflix a competitive advantage over potential competitors. The new crop of Wi-Fi enabled flat screen TVs should also help its positioning.

International expansion presents another opportunity for Netflix to grow its user base. The company recently announced a streaming only option in Canada, which has been surpassing initial growth targets and is expected to become profitable in late 2011. If all continues to go well, Europe will likely be next, probably in the second half of 2011. Because Netflix has virtually no brand recognition in Europe, it will need to invest heavily in marketing. Also, distribution rights need to be negotiated with the studios for every country it enters.

Profits and Competition

Some believe Netflix's profitability will probably suffer if it continues to purchase content at current rates. However, we are more optimistic on the company's ability to meet its long-term gross margin target range of 30%-35% (compares with the 38.3% posted for the nine months ended September 30, 2010). Management has proven well disciplined in the past, and we believe it will walk away from overly expensive deals in order to preserve margins, even if the attractiveness of the service suffers slightly.

Lower postage cost, driven by reduced demand for the mail service, should eventually offset the incremental streaming content acquisition costs. The 10% advance in disk mailings during the third quarter, coupled with the 52% subscriber growth, suggests average mailings per subscriber per month are on the decline. In fact, the company expects to spend more to stream movies than to mail them for the first time in the December quarter.

Still, the mailing aspect of Netflix is here to stay, since the studios are certainly not willing to sacrifice DVD and Video-on-Demand sales by selling new-release content to Netflix. This is why all of the major studios but Disney and Paramount have forced Netflix to wait 28 days until they can start mailing new releases. Recently, three of the six major studios have expressed interest in extending that window beyond 28 days and/or raising prices. This would appear to be a negative for the company.  On the other hand, Netflix would still pay less than if it gained access on the DVD release date. Meanwhile, the studios have been more willing to sell streaming rights for old movies and TV content because of such deals. While it's probably true that content owners will now be looking to charge Netflix more than in the past, we have confidence that the Beverly Hills-based content acquisition team will be able to secure appealing content that viewers may not be willing to buy or rent outright, but would otherwise be interested in watching through Netflix.

We do not view potential competitors as particularly threatening, at this juncture. Amazon has been rumored to be establishing a subscription streaming service that would be bundled with its free 2-day shipping option, Amazon Prime. Some content from its current a la carte rental service would likely be included. Whether Amazon will be able to mount a meaningful competitive threat is an open question, in our view, since we think it would be difficult to amass enough content to lure customers away from Netflix. The same holds true for Google-owned YouTube, which offers a pay-per-view rental and ad-supported streaming service, but has not managed to secure many compelling titles. Reports indicate YouTube is in talks with Miramax for rights to its movies, though. We think most consumers would prefer to get all of their streaming content from one source, and not have to subscribe to multiple services at different prices.

Final Considerations

There is no denying that Netflix management has proven extremely skillful in growing its business, thus far. Continued success will be more difficult, since the days of inexpensive content are long gone. Nevertheless, we have confidence in the company's ability to buy appealing content, to maintain profitability, and to continue growing its subscriber base. Netflix's brand recognition, loyal fan base, and appealing value proposition should help thwart second movers. International expansion opportunities are also attractive. Still, at the current price, it is difficult to argue that the stock is undervalued. We believe the prudent strategy would be to wait for a pull back to capitalize on the potential success of this attractive long-term business model.

 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.