- Domestic Netflix survey data is driving the stock price this week.
- While subscriber data was somewhat disappointing, the pricing implications still seem promising.
- I believe investors will capitalize on an earnings-fueled rally given reasonable revenue assumptions.
So, explaining the abrupt rise in Netflix (NSDQ:NFLX) is somewhat difficult, but can be explained. I believe a lot of this has to do with survey data that was released by the investment banks coupled with the stock being oversold following weak earnings results. But, when given further context into U.S. subscriber trends, the investor base has gotten much more emboldened. After all, anyone familiar with Netflix knows just how volatile the ride can be.
Netflix is known to go through episodic periods of volatility. And after covering this name consistently over the past four-years, it’s not uncommon to walk away from a quarter with double digit declines only to be followed up with another quarter where the stock is sailing off to the moon. This is patterned volatility, which is unlikely to change unless the prevailing investment thesis changes so considerably it would be re-classified as deep value or growth at a reasonable price.
I would say that the underlying investment opportunity is still compelling despite the shaky subscriber figures. Furthermore, I also believe there’s an opportunity to get back into the trade this year given the increased rates for monthly plans, which will eventually drive ARPU metrics higher despite the blend of international subscribers. I will discuss international subscribers in my following article, and will focus more on the qualitative insights from domestic subscribers in this specific article.
On May 22nd, RBC Capital Markets analyst Mark Mahaney released an in-depth report on Netflix. Mark Mahaney has direct access to management and is one of the most reputable Internet analysts on the Street. So, if Mark has something constructive to say, it's virtually guaranteed that many will listen.
Within the report, it was mentioned that roughly 66% of survey respondents were very satisfied or just satisfied, which is strongly indicative of subscriber churn. While Mark Mahaney does mention that the data is not predictive of new subscriber growth, it gives us further insight into whether the weakness in subscriber data in the prior quarter was due to churn or if it was due to slowing penetration.
Given the survey data, however, 89% of respondents were unlikely to churn. Again, a very good point to take into consideration, which leads me to my next conclusion that further penetration into the U.S. demographic is perhaps limited by the number of users per account and the recent pricing increases. However, to be fair Netflix’s subscription revenue is comparable to Walt-Disney’s affiliate fees from its broadcast and cable television segment when combined. So, if you’re looking for a better opportunity elsewhere, you probably won’t find one, as the risks in Netflix are slightly better defined, and the upside is more compelling even when compared to some of the healthier television franchises.
Source: RBC Capital Markets
That being the case, here was an interesting tidbit from RBC that I have never heard before, “To get a sense of how big this free user base is, we asked our Internet users who’ve never been a Netflix subscriber why they haven’t ever been. Unsurprisingly, 26% of them stated that it is because they get it for free, a slight increase from 24% in February. This implies that Netflix may have a modest new Paid Subscriber opportunity with its free-loader segment.”
A good chunk of the user base doesn’t have their own subscription because they share it with someone else. It also implies that the incremental pricing for additional screens helps to adjust for that gap in freeloaders. Personally, I’ve shared my Netflix account in the past with a couple other friends, so it’s not surprising that we’re starting to reach the upper limits to subscriber growth, and we then have to look at pricing for premium or basic plans as the next revenue driver within the United States.
The pricing for basic, standard and premium is $7.99, $9.99 and $11.99 respectively. The basic plan gives access to standard definition content, whereas the two other tiers provide HD content. Since HD TV sets are almost fully penetrated into the United States, and UHD is on its way to mass market adoption it’s likely that pricing will move considerably higher as we progress through the year. The distribution of users between the basic, standard and premium tier is 47%, 38% and 15% respectively. Therefore, Mark Mahaney was able to derive an ARPU (average revenue per user) figure of roughly $9.35/month, which is higher than the $8.69/month reported in the prior quarter.
Some of the discrepancies in ARPU is due to the number of free users still in trial, which slightly reduces ARPU figures, but at the same time if subscriber churn is kept at minimum and users continue to move through the tiers then ARPU will eventually reach the cited figure by RBC Capital Markets. To reduce churn rates, Netflix relies quite heavily on original content, as it’s mentioned that roughly 51% of users were influenced by the original content offerings, whereas the remaining half didn’t factor that into their consideration. Since Netflix has a strong blend of licensed and in-house content it’s nice to know that the breadth and strength of the content library is helping to differentiate the offering when compared to peers.
Furthermore, the increase in ARPU will likely take effect as subscribers either move up the pricing stack, or due to the heightened prices for grandfathered users from May 2014. Pricing will increase by roughly $2 for the older subscribers, which amounts to 36.24 million subscribers or 77% of U.S. subscribers. Of which roughly 38% belong to the standard tier. So, with perhaps 48.47 million total subscribers by the end of 2016, roughly 8.3% y/y growth and better ARPU metrics, revenue will likely surprise.
The ARPU will likely be higher than $9.12 this year as this assumes subscriber mix stays constant between the tiers. However, given the number of users likely to upgrade given the prevalence of HD devices, there’s meaningful upside as a large portion of Netflix users have HD screens. Also, a multiple screen subscription package is greatly advantageous given the number of users who share accounts. Based on my preliminary understanding of revenue trends, and a conservative RBC ARPU ($9.35) figure, I believe domestic streaming will generate roughly $5.438 billion in sales this year compared to $4.181 billion in the prior year, i.e. 30% y/y sales growth. This is above the 5-year consolidated sales growth rate of 25.67% implying revenue acceleration despite a modest drop-off in subscriber growth. This figure blends ARPU for both domestic and international, so it's not an exact measurement, but it gets us closer to the ballpark.
I continue to reiterate my high conviction buy recommendation and $133.42 price target on Netflix stock.