I previewed Netflix’s earnings along with three other companies’ earnings in my Techpinions Insiders post earlier this week. I’ll be doing the same for quite a few more companies this coming Monday. If you haven’t signed up yet, you might want to do so. It’s $10 per month or $100 per year to become a Techpinions Insider, and it includes weekly columns from me as well as several other analysts.
Today, I’m kicking off my formal coverage of Q4 2014 earnings with a post on Netflix’s results, which were published this afternoon. I’ve also created a deck with a more extensive set of charts on Netflix’s performance, which is available through this subscription, also for $10 per month. And with that ends the sales pitch. 🙂
I’m generally pretty bullish on Netflix – I think they’ve created a fantastic value proposition that’s clearly become the gold standard for online video services in the US, and they’re now rapidly expanding that model to the rest of the world too. And that’s a good thing, because growth in the US is starting to slow down. Interestingly, the official reason for that slowdown has changed since last quarter, when the company blamed it on the price increase it instituted in May 2014 (this quote comes from this quarter’s shareholder letter):
In October, we judged the leading factor of the similar decline in Q3 y/y net adds to be our May price change. Since then, with additional research, we now think that the decline in y/y net adds would have largely taken place independent of the price change. We’ve found our growth in net adds is strongest in the lower income areas of the US, which would not be the case if there was material price sensitivity. Additionally, we implemented a similar price change in Mexico during Q4, and saw no detectable change in net additions. We think, instead, the reduction in y/y net additions is a natural progression in our large US market as we grow.
Translation: we’re reaching the point in our US growth where there just aren’t as many new subscribers to sign up as there were in the past, and so growth is going to slow down. You can see this effect in the US streaming subscriber growth numbers:
As you can see, US streaming subscriber growth slowed in Q3, and slowed yet again in Q4, and is likely to continue to slow down in subsequent quarters. Whereas the company has been able to count on 6 million new subs per year in the US, it can no longer do so. All of which makes that international growth all the more important, and that’s accelerating rapidly. This quarter was the first time year on year growth internationally eclipsed domestic growth year on year, and that gap will continue to widen.
This expansion, of course, continues to happen at the cost of profitability, since entering new markets is very costly. As I’ve remarked before, Netflix seems to pick up the pace of international expansion every time the overseas business threatens to become profitable, and margins are currently on a downward slope in the international business:
However, that overall line masks two very different businesses: Netflix’s original overseas markets (Canada, Latin America, the UK, Ireland, the Nordic countries and the Netherlands) are now profitable on a contribution basis, but it’s entered so many new markets that those are dragging down overall performance. It’s now in 50 markets overall, and things are going so well that it’s actually planning to accelerate the rate of expansion such that it’ll be largely done by 2017, while staying profitable overall.
Of course, one major cost of both international expansion and continued growth in a saturating US market is marketing. Marketing costs have never been enormous at Netflix in comparison with content costs, but they are a substantial minority of total expenses. And they’ve been rising over time, both domestically and internationally. There are a couple of different ways to measure this and I’ve included both in the full deck of charts, but here’s one measure that I think is meaningful:
As you can see from that chart, on a trailing four quarter basis, the cost in marketing terms to add a net new paid subscriber has been going up, both in the US and internationally. That cost is still under 10% of revenues in the US, but is over 20% in the rest of the world, reflecting the need to promote awareness of Netflix in many new markets. The good thing, though, is that the cost of revenues (largely driven by content acquisition) continues to shrink as a percentage of revenues, and cost of revenue per paid sub is now lower than revenue per paid sub even internationally:
That means that, as Netflix is able to dial back marketing and other non-content-related expenses, and as scale effects kick in, profitability should be eminently achievable. It’s also on track to become the first truly global video business – something that Apple has arguably come closest to so far, but where Netflix will eclipse its reach in the next year or two.
One last thing I wanted to touch on is a rather unique aspect of Netflix and its financials, which is the very predictable and steady progress in US margins. I don’t know of any other company that could make a statement like this (again, from the shareholder letter):
This year we plan to increase US contribution margins from 30% in Q1 to about 32% in Q1 2016 to about 34% in Q1 2017, etc. We’ll re-evaluate the margin progression model again in early 2020 when we hopefully achieve 40% contribution margins.
What other company talks about a specific margin target for five years out? And seems so likely to be able to achieve that given its past performance? Here’s that US streaming margin line again:
Again, these and quite a few more charts are in the Netflix deck I’ve just put together for subscribers. Sign up here and you’ll receive it by email within a few hours, and others in the coming weeks and months as they become available. A screenshot of the slides in the deck is below: