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Netflix, Inc. (NFLX) Has Solid Upside

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Netflix, Inc. (NASDAQ:NFLX) has been a solid performer in 2013 so far. With such a strong showing under its belt, many investors have become skeptical of Netflix’s upside potential. However, the company’s business model has undergone a material change, and has now evolved into being a content producer, in addition to being a video-distributor. With strong subscriber additions, along with narrowed losses from overseas, Netflix has substantial room to run.

Domestic market can gain further

Netflix, Inc. (NASDAQ:NFLX)

The rapidly growing Netflix, Inc. (NASDAQ:NFLX) added more than 3 million streaming subs across the globe in 1Q13, and surpassed the 36 million subscriber mark. Netflix had 74 overlapping titles with, Inc. (NASDAQ:AMZN) for the top 200 titles, which is pretty much flat from 4Q12. Netflix’s top line revenue grew to $1.024 billion for 1Q13.

Investors have been overjoyed about Netflix, Inc. (NASDAQ:NFLX)’s domestic operations lately. Netflix’s domestic subscriber base saw a healthy increase of more than 2.03 million in Q1 2013, bringing the total U.S. sub base to more than 29.17 million, of which 27.91 million are paying subscribers. The domestic contribution margin of Netflix has seen solid increases in each of the last 5 quarters. The domestic contribution margin stood at 14.3% in Q1 F’12 and increased to 20.6% in 1Q13, which represents a 140 bps increase from the previous sequential quarter.

The continuous expansion in contribution margin increases shows that Netflix, Inc. (NASDAQ:NFLX) is substantially benefiting from economies of scale, as its business operations in the U.S. market gets bigger. Netflix’s management is expecting the target contribution margin ramp of 100bps each quarter.

According to SNL Kagan, Netflix, Inc. (NASDAQ:NFLX) had surpassed the subscriber base of Time Warner Inc (NYSE:TWX)‘s HBO unit, which grew to 28.77 million subs in the U.S., which is a modest addition of only 50,000 subs in 1Q13. Netflix’s relatively simple business model along with a lower price point has aided the company in its surge ahead of HBO. However, HBO is a mammoth in the production of high quality content and earns a lot of profits due to a much higher retail price of roughly $15.

International Subs Has a Big Addressable Market; DVD is not unwinding

However, the real growth story of Netflix is firmly rooted in its international operations. The company is losing money from its international business, a phenomenon likely to continue for another 2 years, according to the company’s management. Netflix’s international subscriber base increased a healthy 1.03 million to end 1Q13 at 7.14 million subs.

Revenues from Netflix’s International Operations contributed 14% of global revenues for Netflix. The company saw reduced losses or improved profit levels across all of its International Segments. And the company is not expecting an improvement in profitability for its International operations because it will ramp up its content library in line with revenue growth.

Netflix added more payment options in the LatAm region, which was a decent headwind for the company’s growth in that geography. Netflix launched in an additional European market in 2Q13 which was the Netherlands. Netflix will be adding more International markets which will be dependent upon the company’s global profitability and the growth prospects of the respective geographies. Once Netflix achieves the scale in a certain geography, it will be able to deliver a long-term stream of profits due to its business model.

The company’s DVD business is declining at a much slower pace than previously expected, and ended Q1 at 7.98 million subscribers. Netflix’s DVD segment had a $113 million contribution profit which represented a contribution margin of 46.6%, the sequential decline in DVD contribution margin is due to higher usage historically in Q1. And the margins are likely to remain in this level, as a lot of subscribers still like to watch movies from physical discs.

Signing mix of original and exclusive content deals

Netflix recently signed long-term content deals with Time Warner Inc (NYSE:TWX) subsidiaries, Turner Broadcasting and Warner Bros. for adding a number of popular shows produced by various arms of Time Warner. Netflix is increasingly leaning towards being a curator of popular TV Shows and movies, instead of bulk content deals from studios and producers.

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