Netflix, Inc. Investors Will Need Strong Stomachs
Investors in Netflix had a great 2013 -- and they've found nothing to complain about in the first few months of 2014, either. In fact, Netflix shares have risen nearly 400% since the beginning of last year.
Netflix Stock Chart 2013-present, data by YCharts
These astounding gains have come as Netflix has shown continuous improvement on virtually every relevant performance metric. As high as Netflix stock has gone, investors have found new reasons to drive it even higher in each quarterly earnings report.
However, 2014 isn't likely to be as smooth a year for Netflix investors. To be sure, Netflix is likely to post strong revenue and earnings growth once again. Nevertheless, there are several potential bumps in the road that investors seem to be minimizing. Given its extremely high valuation, Netflix stock is not likely to react well to any deviation from the trajectory of constantly increasing revenue and earnings.
The spring slowdown
The first pothole Netflix will have to navigate is the "spring slowdown." Q2 is a seasonally weak period for Netflix, and the company routinely posts its lowest subscriber growth totals in Q2. As the weather improves in the Northern Hemisphere, people are more likely to spend time outdoors rather than planning binge-watching sessions on Netflix.
Netflix could see a slowdown in subscriber growth as the weather improves this spring.
Two years ago, Netflix gave a detailed explanation of how this seasonality becomes increasingly pronounced as the total subscriber base grows. As a result, Netflix told investors to expect that Q2 subscriber additions will decline each year.
That didn't happen in 2013, though. Last year, Netflix added 630,000 domestic subscribers in Q2, up from 530,000 net domestic additions in Q2 2012. The company attributed this strong performance to launching the 4th season of Arrested Development during the quarter. Arrested Development already had an existing fan base, and some of these people started Netflix subscriptions last spring in order to watch the new season.
Netflix doesn't have anything equivalent coming this spring. As a result, the subscriber growth trajectory is likely to return to the historical pattern -- as Netflix's management stated in its most recent quarterly investor letter. Not only will domestic subscriber growth likely fall below last year's 630,000 net additions, it could also fall below the prior year's 530,000 net additions for Q2.
From a long-term perspective, this shouldn't be alarming: It's just the impact of seasonality. However, it would still be the first time since mid-2012 that domestic subscriber growth was down year over year. That alone could cause speculators who have flooded into Netflix stock in the last year to flee.
The cost of going global
In Netflix's Q4 investor letter, the company announced plans for a "substantial European expansion" later this year. Earlier this month, CFO David Wells explained that the company is using the word "substantial" to indicate that this expansion will be much bigger than last year's entry into the Netherlands.
Netflix may be taking its talents to France, Germany, and Belgium this fall.
Netflix may be looking at entering France, Germany, and Belgium this year, according to The Hollywood Reporter. If that country list is accurate, it would be the boldest move Netflix has made since launching in Latin America in 2011. Combined, the three countries have a population of nearly 160 million, compared with less than 17 million in the Netherlands.
This creates a big long-term opportunity for Netflix -- but also big short-term costs. Netflix has to license content before entering a new market, and the cost of licensing content scales up with the size of the market. Additionally, Netflix needs to invest in advertising to boost consumer awareness.
On the other hand, revenue is initially very low and builds gradually as Netflix acquires more subscribers. As a result, launching new markets is expensive. Cumulatively, Netflix has lost nearly $800 million in its international markets so far. Moreover, every time Netflix adds a new international market, its quarterly international loss rises.
For example, in Q3 last year, Netflix saw flat or improved profitability in all of its international markets. However, the quarterly contribution loss increased by $8 million sequentially, because of the cost of launching in the Netherlands in September. This implies that the Netherlands loss may have been $10 million-$15 million.
The cost of acquiring content means Netflix's new markets take a few years to become profitable.
If start-up costs increase in proportion to the size of a market, a France/Germany/Belgium launch could cause the international quarterly loss to jump by up to $100 million (based on the impact of other recent launches on Netflix's international profitability). An increase in international losses of this magnitude would cause a significant drop in EPS -- it could not be fully offset by higher domestic earnings.
Nevertheless, analysts on average expect Netflix to earn more money in the second half of 2014 than in the first half of the year. It may be that some analysts have not factored in international expansion costs yet because they cannot be quantified until Netflix announces which markets it will enter and when.
Whatever the cause, analysts will probably need to drastically cut their second half earnings estimates after Netflix announces its expansion plans. Changes in earnings estimates correlate very well with stock price moves -- so Netflix's international expansion could be very bad for Netflix stock, even if it's the right move from a business perspective.
Netflix stock has flown too high
Fundamentally, Netflix is a well-managed company with strong growth prospects but an out-of-control stock price. Many analysts seem to be underestimating the potential for a spring slowdown in subscriber growth -- and completely ignoring the likely cost of Netflix's European expansion.
Moreover, Netflix investors have been "spoiled" by constant improvement in almost every relevant metric for the last year and a half. Some investors seem to expect this to continue with no pauses and no setbacks. However, Netflix's profit growth trajectory is likely to hit some bumps this year. As investors ratchet down their expectations, Netflix stock could fall back to earth.
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The article Netflix, Inc. Investors Will Need Strong Stomachs originally appeared on Fool.com.
Adam Levine-Weinberg is short shares of Netflix. The Motley Fool recommends and owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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