Higher Costs Will Not Hamper Netflix Earnings Growth

  • Netflix has had to pay interconnection fees to various ISP's over the past year which, according to the company, will be a part of their long-term cost structure.
  • However, the company believes that it will improve Netflix profitability despite increasing delivery costs, which will become a barrier of entry to the streaming video on demand market.
  • Netflix earnings are expected to grow at a fairly considerable rate over the next five years.
netflix higher interconnection fees

The broader trend in online video consumption has weighed heavily on bandwidth from internet service providers. While the problem isn't just limited to Netflix (NASDAQ:NFLX), it’s likely that fees paid to ISP's will increase. Internet service providers have to increase bandwidth to keep pace with data traffic.

Despite the shortcomings in Netflix’s business model, the stock looks well positioned for growth, as management has indicated that it can improve its cost structure despite the fees it will end up paying for better bandwidth.

More Data, More Fees, But Netflix Still Scales

Global IP traffic growth
Source: Cisco

It’s estimated that between 2013, and 2018, global traffic will increase by 3 times as much. Most of this will be driven by video, which will account for 76% of internet traffic by 2018, according to Cisco. To address traffic growth, ways to improve network capacity have to be developed.

Netflix argues that its in-house interconnection efforts have eased the load off of internet service providers. Netflix addresses network traffic through Netflix Open connect, which is a content delivery network in which data is stored near subscribers to reduce redundancy in bandwidth. By transferring data over shorter distances, there’s more bandwidth available for the entire network.

However, beyond network interconnection, Netflix has also paid internet service providers, so they can deliver faster speeds. Depending on how regulators define net neutrality will determine whether or not Netflix will have to pay internet service providers fees for faster content delivery.

According to a post on lash Gear:

Comcast began severely throttling customers' Netflix experience early this year, resulting in many frustrated and angry customers who, says Netflix, contacted the company in quadrupled numbers over average. Because the streaming quality was so poor -- and sometimes impossible -- many customers dropped the service. The customers it was losing forced Netflix to enter into an agreement with Comcast after a couple months, and that has snowballed into similar agreements with Verizon and more.

Netflix hours streamed per subscriber per month
Source: TDG

In the past quarter alone, GIGAOM estimates that the average Netflix user consumed 45 GB of data per month. This trend has steadily increased over the past two years, and it’s likely to increase over the next five years, and at a pretty considerable rate.

Netflix does offer meaningful assertion though that despite various fees for interconnection, the company will still be on track to reach its contribution margin targets.

According to David Wells (CFO of Netflix):

On a short term basis I think there is great assurances in the sense that we’ve been able to sign these immediate interconnect deals and still able to achieve our margin targets. And when our guidance implies these costs are embedded. So I do think it’s about a long term cost and we’ll see where we go from here in terms of years. I think for Netflix content is our largest cost. It dwarfs all the other costs so I think it’s really about profit margin at that point and in terms of how much margin goes to a delivery cost versus other cost in our business, we would rather spend it on content.

Netflix offered guidance that its contribution margin in the United States will increase by 400 basis points per quarter until the end of 2015. Netflix believes that content acquisition will remain its largest cost. However, it believes that it can reach its margin targets, without compromising the user experience.

Conclusion

Because Netflix’s cost structure continues to scale despite interconnection fees, Netflix’s growth trajectory remains intact. However, smaller scale competitors may find interconnection fees a significant barrier of entry into streaming video on demand.

Netflix revenue is expected to grow at a much higher rate due to further expansion into Europe, higher pricing, and domestic subscriber growth. Profitability trends have improved domestically and it’s likely that the international segment will break-even in a couple more years. Profitability will come as a result of revenue growing at a slightly higher rate than costs, which is why analysts on a consensus basis are estimating EPS to grow 33.22% per year over the next five years.

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