Netflix, Inc. (NFLX) Stock: Are Recent Gains Sustainable?

Netflix, Inc. (NASDAQ:NFLX)Netflix, Inc. (NASDAQ:NFLX) has  became a standalone video streaming service during 2011, as it shifted its entire focus from the DVD business to video streaming. The shift in focus was inspired by rising internet penetration, higher broadband speed and a rapid growth in demand for internet enabled devices.

As the competition in the video streaming space increases, Netflix, Inc. (NASDAQ:NFLX) is making a serious push in offering original programming. Last month, for instance, the online video streaming company announced the production of a new series by Matrix creators the Wachowskis and Babylon 5 creator Joe Straczynski called the “Sense8.”

Netflix, Inc. (NASDAQ:NFLX) recently reported Q1 2013 results. Below is a snapshot of Netflix’s performance.

Q1 fiscal 2013

Netflix, Inc. (NASDAQ:NFLX)’s share price appreciated by approximately 25% soon after the company reported a strong increase in subscribers coupled with growth in margins. During the last quarter of fiscal 2012, Netflix managed to add a little more than 2 million domestic streaming subscribers, which led to a healthy 5.5 million new-subscriber additions for the entire fiscal 2012.

Netflix carried the momentum into the first quarter of 2013, as it added another 2 million domestic subscribers to its already-hefty subscriber base. Furthermore, the DVD business, which has been struggling for a while now, reported a reduction in subscriber loss for the fifth-straight quarter.

While the results exhibited by Netflix, Inc. (NASDAQ:NFLX) are essentially positive, its current stock price still seems slightly overvalued, given the rising competition in the US market and an overall decline in the  DVD business.

I believe there is a huge opportunity for Netflix to grow internationally; nevertheless, losses incurred by the company suggests that its international streaming business is still not generating enough FCF to add any value to its current stock price.

What is driving Netflix’s growth in the U.S. market?

Netflix, Inc. (NASDAQ:NFLX)’s success in the U.S. is predominantly based on its exclusive content offerings. It must be noted that the company has added original programming to its domestic streaming library. TV-series’ such as Arrested Development and House of Cards have enabled the company to draw numerous new subscribers.

Additionally, Netflix has also benefited by increasing Internet penetration and a huge surge in demand for Internet enabled devices such as smartphones and tablets. Even though the competition is rising in the U.S, I believe Netflix, Inc. (NASDAQ:NFLX) has an early-mover advantage, as it is a leading player in streaming services.

In addition to the TV-series mentioned earlier, Netflix also managed to strike a deal with The Walt Disney Company (NYSE:DIS) to acquire exclusive rights to some of its content after 2015. During Q1 fiscal 2013, Netflix incrementally developed its streaming content by striking exclusive deals with Turner Broadcasting and Warner Bros.

According to forecast provided by Trefis, Netflix’s present streaming subscriber base in the U.S. is estimated to grow from 27 million during 2012 to 45 million by the end of 2019.

International growth

During the first quarter for fiscal 2013, Netflix, Inc. (NASDAQ:NFLX) exhibited strong international growth, as it added nearly one-million new subscribers, which takes its total to 7.1 million subscribers. In addition, Netflix also reported better earnings in all international markets, as losses were reduced by $28 million.

At present, Netflix has a presence across Europe and Canada, and considering these are well-developed markets, it would be fair to assume Netflix is well placed to increase its international subscriber base by capitalizing on the opportunities presented by both of these regions. The Internet penetration in Europe and Canada is extremely high and the average speed offered by broadband providers is good enough to support streaming services.

The total size of the addressable market in Europe for Netflix is close to 38 million households; however, the company can add another 30% if it manages to replicate the success it had in the U.S.

Latin America presents another huge growth opportunity for Netflix. Although Netflix has experienced a sluggish start in this region, I believe the growing broadband penetration in Latin America coupled with increasing disposable incomes for the middle class and lack of pay-TV choices can facilitate Netflix into capturing a higher market share.

According to Trefis market share estimates, a 5% penetration in this region could lead to a gain of 8-million new subscribers over the next seven years.

Lower valuation

Netflix’s DVD business has witnessed a sharp decline in the past few years. Netflix’s DVD subscribers declined from 19 million during 2010 to 8.2 million by the end of fiscal 2012. The decline in the DVD business is inversely related to its streaming business; hence, I expect the decline to continue with ever-improving streaming services. The subscriber loss during the first quarter of fiscal 2013 was approximately 240,000.

The DVD rental business operates on a high margin, and although Netflix is expected to sustain its current margins during this year, the decline of the business division seems certain with a consistently decreasing subscriber base.

A large component of the cost structure in the DVD business is related to content acquisition, DVD shipments and postage. While the postage cost can be considered as variable, other costs are relatively fixed. It must be noted that fixed costs associated with content acquisitions will eventually be distributed across a lesser proportion of revenue due to the decline in subscriber base, which will result in a much higher degree of leverage (DOL) for Netflix.

Investors should take into account that high variable costs stay in proportion with sales; however, high fixed costs will reduce the probability of firms breaking even in a scenario of declining sales, which subsequently leads to financial distress.