SVOD leader Netflix may be seeing record growth, but it continues to struggle with its margins as content costs rise and, says one analyst, profit expectations in its stock price are unrealistically high.
"It is almost becoming an expected event every quarter: Netflix releases quarterly earnings amid much speculation about its future, and the price soars," said David Trainer, a research analyst with New Constructs. . "We're not talking about Netflix's stock price though - Netflix's streaming content obligations continue to soar year in and year out."
Content costs have been rising since 2010 for the company, but saturation has been slowing down its growth domestically on a quarter-over-quarter basis. Tracking this, Trainer has long been a Netflix naysayer—this time last year he made a similar assessment of Netflix, pronouncing the company to be in permanent decline.to be in permanent decline. In 2013, the company saw margin compression, fierce competition and high content costs, challenging its underlying financial fundamentals. And the story hasn't changed much.
Consider: Netflix added only 1.9 million subscribers to its US streaming segment in the fourth quarter of 2014, down from 2.3 million the prior year. At the same time, versus 2013, Netflix's 2014 streaming content obligations increased 30% to $9.5 billion. Overall, revenue only increased 7% in 2014.
Trainer didn't sugarcoat his assessment: "Investors who own this stock are playing a dangerous game with momentum. When the music stops on Netflix, the stock will likely get crushed."
And while Netflix is still adding subscribers—albeit at a slowing pace—Trainer pointed out that those subscribers are less and less profitable. The US segment's contribution margin declined to 28%, down from 29% the prior quarter.
What about internationally, where the company has started making good on its grand plans to expand across the globe? Here things look even worse. The international segment's contribution margin plummeted to -20% in Q4, from -9% the prior quarter. The expansion, in short, is costing a lot of money, and the growth rate needs to increase substantially to recoup the investment. In 2014 the company added only 2.4 million members. That's up from 1.7 million the year before but it's not nearly enough to be profitable.
Trainer also noted that competition is starting to impact the No. 1 streaming company's power—and to lessen the impact that original content has on differentiation.
"At its core, Netflix is merely a content delivery platform - and one of many," he said. "From Amazon video services to CBS All Access to HBO Go and Dish Network's new Sling TV, there is no shortage of competition in this space, and none of them stand out as offering anything that is really unique. Netflix is attempting to separate itself by creating original content only available to Netflix subscribers, but it is no longer the only player in that game. Competitor Amazon has established itself as a formidable competitor, recently winning two Golden Globes."
Making matters worse, original content creation is expensive and risky, which is why most movie studios are owned by larger media conglomerates that can afford to take the big risks that making blockbuster movies often takes.
Right now, Netflix is operating with a 7.5% pre-tax margin, and has 57 million subscribers. Trainer thinks that at a bare minimum, the company needs to charge the higher prices to generate the profits already embedded in its stock price. But, competition will make that difficult. So as it stands, Netflix is one of the most overvalued stocks on the exchange, he argues.
"To justify its current price of ~$418/share, NFLX would need to grow revenue by 20% compounded annually for the next 22 years," Trainer said. "Essentially, Netflix needs to significantly increase its margins, expand its customer base by adding more content, and not pay as much for that content. Sounds about the opposite of what the company is currently doing doesn't it?"